The Capital Stack

What you'll be able to do

• Rank the layers of the capital stack by risk, return and priority of payment.
• Explain why investors use debt (three strategic reasons).
• Tell apart mezzanine debt, preferred equity and common equity.
• Read a GP/LP waterfall and explain the promote.

Builds on Unit 1 (leverage & levered IRR) and Unit 3 (mortgages).

The capital stack

Most real estate deals are financed with a mix of debt and equity, stacked by priority. From safest/lowest return at the bottom to riskiest/highest return at the top:

• Senior debt (the mortgage) — paid first, lowest cost, lowest risk.
• Mezzanine debt — subordinate to senior debt, higher rate.
• Preferred equity — hybrid; paid before common equity, fixed-ish return.
• Common equity (LP + GP) — paid last, takes the first loss, but captures all the upside.

Two rules follow from the order:

1. Priority of payment runs bottom-up: senior debt is served before anyone above it.
2. Risk and return rise as you go up the stack — the last-paid money demands the highest return.

Deeper dive — why project-level debt, and the four 'other' reasons

Real estate uses project- (asset-) level secured financing far more than corporate finance because it is asset-heavy and transparent: value sits in tangible property that makes ideal collateral, so outside investors can lend or invest without day-to-day control. There are three primary reasons to use debt: an equity capital constraint, leveraging expertise (development / operational / asset-management talent that can't be deployed without borrowed funds), and diversification — €10m of equity buys two €5m buildings unleveraged, but eight at 75% LTV.

Four further considerations: debt lets you create products that match risk to investor appetite (debt = lower-risk/income/fixed-horizon; equity = higher-risk/growth/open-horizon); debt is an incentive and disciplinary tool ('75% LTV turns a 1% return impact into a 4% impact', attracting active management); debt provides liquidity (you can partially cash out an illiquid asset by borrowing — until fully levered); and fixed-rate debt is an inflation hedge against unexpected inflation ('reverse-inflation risk'), because rents track inflation while debt service stays fixed. The stack, senior to residual: First mortgage → Mezzanine (junior) debt → Preferred equity → Common equity (capital partner) → Common equity (entrepreneurial partner). For priority of payments, separate operating distributions (which pay the preferred dividend) from capital events like a sale (which pay return of capital).

Worked example — leverage and diversification

Investor with €10m of equity:

• Unleveraged: 10,000,000 / 5,000,000 = 2 properties.
• At 75% LTV: equity per €5m asset = 0.25 × 5,000,000 = €1.25m → 10,000,000 / 1,250,000 = 8 properties (€40m of assets on €30m debt + €10m equity).
• Return amplification: at 4:1 asset-to-equity, a 1% swing in property return ≈ a 4% swing in equity return.