Definition
The capital stack is the layered structure of financing used to acquire or develop a property. It includes various forms of debt and equity, ranked by priority of repayment and risk exposure.
Typical Capital Stack Structure
- Senior Debt – First priority repayment, lowest risk.
- Mezzanine Debt – Subordinate to senior debt, higher yield.
- Preferred Equity – Priority over common equity, fixed or preferred return.
- Common Equity – Highest risk, highest potential return.
Repayment Priority
In a sale or liquidation:
- Senior lender gets paid first.
- Subordinate lenders next.
- Preferred equity investors next.
- Common equity investors last.
Risk and Return Relationship
- Lower in stack = higher risk.
- Higher in stack = lower risk.
- Higher risk layers demand higher returns.
Example
A $10 million acquisition may be financed as:
- $6.5M Senior Loan (65%)
- $1M Mezzanine Debt (10%)
- $500K Preferred Equity (5%)
- $2M Common Equity (20%)
Each layer carries different risk and compensation expectations.
Relation to Distribution Waterfalls
Equity layers often operate under a waterfall distribution structure, where return of capital and preferred return are paid before promote participation.
Strategic Considerations
- Higher leverage increases equity returns but adds risk.
- Mezzanine layers increase cost of capital.
- Institutional lenders favor stabilized assets.
- Non-recourse structures alter risk distribution.
Common Investor Mistakes
- Over-leveraging to boost IRR
- Ignoring refinance risk
- Misunderstanding subordination terms
- Underestimating debt service coverage requirements
Investor Checklist
- Model stress scenarios.
- Understand repayment priority.
- Review intercreditor agreements.
- Evaluate blended cost of capital.
- Align capital structure with business plan risk.
Strategic Insight
The capital stack determines who wins — and who absorbs losses — under every scenario. Sophisticated investors design capital structures to balance growth with durability.