What is Capital Stack?
The capital stack represents the layered structure of financing used to fund a real estate investment. It organizes all sources of capital—from debt to equity—in order of priority for repayment and risk exposure.
Each layer of the capital stack has different rights, returns, and risks. The structure determines who gets paid first in a successful deal and who absorbs losses first if the investment underperforms.
Understanding the capital stack is essential for investors, lenders, and developers who need to evaluate risk, negotiate terms, and project returns.
How Does Capital Stack Work?
The capital stack works by stacking different types of financing in a hierarchy. At the bottom sits senior debt, which has the highest claim on cash flow and assets. Above that comes mezzanine debt, then preferred equity, and finally common equity at the top.
Senior lenders take the least risk because they’re first in line for repayment. In exchange, they accept lower returns, typically in the form of interest payments. As you move up the stack, each layer assumes more risk and demands higher potential returns.
If a property generates income or sells, payments flow from the bottom up. Senior debt gets paid first, followed by each successive layer. Conversely, if the investment loses value, common equity absorbs losses first, protecting the layers below.
Capital Stack Structure
The capital stack typically follows this hierarchy from bottom to top:
Senior Debt (60-75% of total capital): First-position mortgage loans with the lowest interest rates, usually 4-7% annually. These lenders have first claim on property cash flow and assets.
Mezzanine Debt (10-15% of total capital): Subordinated loans sitting between senior debt and equity, offering returns of 10-15% annually. These lenders accept higher risk for higher yields.
Preferred Equity (5-15% of total capital): Equity investment with priority over common equity, typically targeting 12-18% annual returns with a preferred distribution rate.
Common Equity (10-20% of total capital): The top layer owned by sponsors and investors who take maximum risk and receive residual profits after all other layers are paid, often targeting 18-25%+ returns.
Real-World Application of Capital Stack in Real Estate
Consider a $50 million multifamily development in a growing submarket. The developer structures the capital stack with $35 million in senior debt from a bank, $7.5 million in mezzanine financing, and $7.5 million in equity from investors and the sponsor.
The senior lender receives fixed interest payments regardless of the property’s performance, as long as it generates sufficient cash flow. The mezzanine lender earns higher interest but stands behind senior debt if foreclosure occurs.
Equity investors share in the property’s upside. If the submarket’s absorption rate remains strong and the building leases quickly, they capture profits after debt obligations are met. However, if the shadow market releases unexpected competing units and occupancy drops, equity investors bear the first losses while debt holders remain relatively protected.
This layered approach allows the developer to raise sufficient capital while offering risk-adjusted returns to different investor types. It also provides flexibility in structuring deals when single financing sources can’t or won’t fund entire projects.
How Capital Stack Is Used
Developers and sponsors use the capital stack to minimize their equity contribution while maximizing leverage. By layering different financing types, they can pursue larger projects than their available capital would otherwise allow.
Investors use the capital stack to select positions matching their risk tolerance and return expectations. Conservative investors gravitate toward senior debt or mezzanine positions, while aggressive investors pursue equity stakes with higher upside potential.
Lenders and underwriters analyze the capital stack to assess deal feasibility and protection. They evaluate whether each layer has appropriate coverage ratios and whether the total leverage aligns with the property type, market conditions, and sponsor experience.
The capital stack also guides waterfall distribution schedules, determining how cash flow and sale proceeds are allocated among stakeholders throughout the investment lifecycle.
Capital Stack in Other Words
Think of the capital stack as a building’s foundation and floors. The foundation—senior debt—provides stability and supports everything above it. It doesn’t move much and doesn’t expect dramatic returns, just steady, reliable performance.
Each floor above represents progressively riskier capital. The higher you climb, the more the building sways in the wind. Those on the top floor experience the most volatility but enjoy the best views and greatest rewards when conditions are favorable.
When the building thrives, everyone benefits, but those at the top benefit most. When it struggles, the top floors feel the impact first, while the foundation remains secure. This hierarchy ensures that each participant receives compensation proportional to their risk exposure.
