A property deal is paid for in layers called the capital stack: senior debt, mezzanine debt, preferred equity and common equity. Each layer is paid in full before the next gets anything, like water filling a tower of glasses from the top. A layer’s risk depends on its attachment point: how far the property’s value can fall before that layer starts losing money. Leverage changes the return on the owner’s equity, not the return on the building.
Why it matters: The same building can be a safe or a risky bet depending on which layer you own.
Summary: A property is financed by a capital stack: senior debt, mezzanine debt, preferred equity and common equity, each paid in full before the next receives anything. Each layer’s risk is set by its attachment point, the fall in value at which it starts to lose money, and leverage changes the return on equity, not on the building.
- In a $50M deal with 20% common equity, a 10% fall in value costs the sponsor half its money while the senior lender loses nothing.
- Preferred equity is wiped out at a 25% fall in that deal, despite its fixed coupon.
- Leverage adds to equity returns only while the cap rate exceeds the loan rate; otherwise it is negative leverage.
- A 20% promote over an 8% preferred return gave the sponsor a 24.2% IRR and investors 13.6% on a deal earning 14.9%.
A real estate or infrastructure asset is almost never financed by a single source of capital — it is built from layered claims called the capital stack, ranked by priority of repayment, echoing the capital structure concepts from The Practitioner’s Codex Part 1 but applied specifically to a single physical asset rather than an entire operating company.
| Layer (Highest Priority First) | Typical Share of Capital | Risk/Return Profile |
|---|---|---|
| Senior Debt | 60–75% | Lowest risk, lowest return — repaid first, secured directly against the property itself |
| Mezzanine Debt | 0–15% | Subordinated to senior debt but ranks above equity — higher interest rate compensating for the added risk |
| Preferred Equity | 0–10% | Ranks below all debt but ahead of common equity — often a fixed preferred return before common equity holders receive anything |
| Common Equity | 10–30% | Highest risk, highest potential return — the developer/sponsor’s own capital, absorbing losses first but capturing all remaining upside |
A $50M building is financed with $32.5M of senior debt (65%), $5.0M of mezzanine (10%), $2.5M of preferred equity (5%) and $10.0M of common equity (20%). Each layer’s attachment point is the fall in value at which it starts to lose money: common equity from the first dollar, preferred beyond 20%, mezzanine beyond 25%, senior debt beyond 35%. Assume a sale with no accrued interest or costs (both push every attachment point lower in practice).
| Scenario | Sale price | Senior | Mezzanine | Preferred | Common |
|---|---|---|---|---|---|
| Value −10% | $45.0M | $32.5M (0%) | $5.0M (0%) | $2.5M (0%) | $5.0M (−50%) |
| Value −30% | $35.0M | $32.5M (0%) | $2.5M (−50%) | $0 (−100%) | $0 (−100%) |
| Value −45% | $27.5M | $27.5M (−15.4%) | $0 (−100%) | $0 (−100%) | $0 (−100%) |
Flip points: common equity is wiped out at a 20% fall ($10.0M ÷ $50M), preferred at 25%, mezzanine at 35%. A 10% fall costs the sponsor half its money while the senior lender loses nothing.
The capital stack’s strict repayment priority is precisely what allows a single property to attract capital from investors with completely different risk appetites simultaneously — a conservative pension fund can hold the senior debt for a modest, secure return, while a real estate developer holds the common equity, accepting far more risk for the chance at outsized returns from the exact same building.
Leverage changes the return on equity, not on the building. The unlevered return is NOI plus the change in value, divided by price; the levered return follows Modigliani–Miller’s second proposition (The Practitioner’s Codex §1.6): unlevered return + (unlevered return − cost of debt) × debt ÷ equity. Buy the $50M building at a 6.5% cap rate (NOI $3.25M; cap rates are explained in Section 2.2: Cap Rates and Property Valuation) with $32.5M of interest-only debt at 6.0% (interest $1.95M) and $17.5M of equity; sell after one year.
- Sale at $52M: unlevered = ($3.25M + $2.0M) ÷ $50M = 10.5%; levered = ($3.25M − $1.95M + $2.0M) ÷ $17.5M = 18.9%. Check: 10.5% + (10.5% − 6.0%) × 1.857 = 18.9%.
- Sale at $46M: unlevered = ($3.25M − $4.0M) ÷ $50M = −1.5%; levered = ($3.25M − $1.95M − $4.0M) ÷ $17.5M = −15.4%.
Leverage helps here because the 6.5% cap rate exceeds the 6.0% loan rate: equity’s cash yield is ($3.25M − $1.95M) ÷ $17.5M = 7.4%. With the loan rate above the cap rate, the position has negative leverage: each borrowed dollar lowers the equity’s cash yield.
Common equity is usually split between a sponsor (the general partner, GP), which runs the deal with a small stake, and investors (limited partners, LPs). A distribution waterfall pays capital back, then a preferred return, then gives the sponsor a disproportionate share of the rest, the promote, the real estate cousin of carried interest (The Practitioner’s Codex §2.8). Illustrative: $20M of equity (LPs $18M, GP $2M), an 8% compounding preferred return, then 80% pro rata and 20% promote; one exit after five years for $40M. Tier 1 returns $20.00M of capital. Tier 2 pays $20M × (1.085 − 1) = $9.39M. Tier 3 splits the remaining $10.61M: $2.12M promote to the GP, $8.49M pro rata.
LPs receive $34.09M (IRR 13.6%); the GP receives $5.91M (IRR 24.2%) on a deal that earned 14.9%. With 10% of the equity, the GP takes 19.6% of the profit. Below the hurdle the payoff flips: at a $28M exit both earn 7.0%, and the sponsor’s promote behaves like an out-of-the-money option, which rewards it for taking more risk with investors’ money. That is why LPs negotiate hurdles, catch-ups and clawbacks hard.
Before buying into any layer, compute its attachment and detachment points (the falls in value at which it starts losing and is wiped out). If you lend senior, the layers beneath you should cover at least the fall this property type suffered in its last serious downturn; price mezzanine or preferred equity attaching below about a 25% fall as equity risk with a capped upside. These are heuristics, weaker for long leases to investment-grade tenants.
Treating preferred equity or mezzanine as “debt-like” because it pays a fixed coupon. In the $50M example, a 30% fall wipes out the whole $2.5M preferred layer and half the $5.0M mezzanine while the senior lender loses nothing: a fixed coupon with an equity-sized loss. Price each layer on its attachment point, not its coupon.
What is the capital stack in real estate?
The capital stack is the ranked set of claims funding one property: senior debt, mezzanine debt, preferred equity, then common equity. Each layer is paid in full before the next gets anything, so each has its own risk and price. Senior lenders accept low returns because the layers below absorb the first 25–40% of losses.
Is preferred equity debt or equity?
Preferred equity is equity: it ranks below every loan and holds no mortgage. Its fixed preferred return and priority over common equity make it look like debt, but if value falls it is wiped out before any lender loses a dollar, at a 25% fall in the worked example.
What is a promote in real estate?
A promote is the extra share of profit a sponsor earns above its pro rata share once investors have their capital back plus a preferred return. With a 20% promote over an 8% preferred return, the sponsor in the worked example earns a 24.2% IRR and its investors 13.6%.
The capital stack ranks senior debt, mezzanine debt, preferred equity and common equity by repayment priority, and each layer’s risk is set by its attachment point rather than its coupon: in the $50M example common equity is wiped out at a 20% fall and preferred equity at 25%. Leverage raises equity returns only while the cap rate exceeds the cost of debt, and a promote over a preferred return gives the sponsor an option-like share of the upside.
Four questions on this chapter. Decide on your answer first, then click “Reveal Answer.”
1. A $40M building is financed with $26M of senior debt, $4M of mezzanine, $2M of preferred equity and $8M of common equity. It sells for $31M with no costs or accrued interest. What does the preferred equity receive?
- $2M, no loss
- $1.5M, a 25% loss
- $1M, a 50% loss
- $0, a total loss
Reveal Answer
Answer: C. Senior takes $26M and mezzanine $4M, leaving $31M − $30M = $1M of the $2M preferred layer; common equity gets nothing.
2. You buy a $20M building with $1.4M of NOI using a $12M interest-only loan at 5% and sell it a year later for $21M. What is the levered return on equity?
- 12.0%
- 22.5%
- 17.5%
- 27.5%
Reveal Answer
Answer: B. Levered return = ($1.4M − $0.6M interest + $1.0M gain) ÷ $8M equity = 22.5%, against an unlevered ($1.4M + $1.0M) ÷ $20M = 12.0%.
3. A property bought at a 5.0% cap rate is financed with an interest-only loan at 6.5%. What does borrowing more on these terms do to the equity’s cash yield?
- It raises the yield on the building
- It leaves the cash yield unchanged
- It raises the equity’s cash yield
- It lowers the equity’s cash yield
Reveal Answer
Answer: D. With the loan rate above the cap rate, each borrowed dollar costs more than the income it finances: negative leverage.
4. Why do limited partners negotiate preferred returns, catch-ups and clawbacks hard around the sponsor’s promote in a real estate waterfall?
- Its option-like payoff rewards the sponsor for taking extra risk
- It is paid before investors recover any of their invested capital
- It caps the sponsor’s profit share at its pro rata equity stake
- It is a fixed annual fee that does not depend on deal profits
Reveal Answer
Answer: A. The sponsor shares heavily in gains above the hurdle but little in losses, so its payoff resembles a call option on the deal.