Capital stack

Expanded explanation

The capital stack describes every source of money used to buy or build an asset, arranged by legal priority. Priority determines two things at once: who gets paid first from cash flow and sale proceeds, and who absorbs losses first when the asset underperforms.

The term is most common in commercial real estate, but the structure applies to any leveraged investment, including private credit deals, infrastructure projects and corporate buyouts. Whenever an offering describes a position as "senior", "mezzanine", "preferred" or "common", it is describing a place in the stack.

Position, not asset quality alone, explains most of the difference in expected return between two investments in the same building.

How it works

From the bottom of the stack (paid first, lowest expected return) upward:

1. Senior debt — a first mortgage or first-lien loan. Contractual interest, collateral security, and the first claim on proceeds. Lowest expected return.
2. Mezzanine debt — subordinated debt, often secured by a pledge of ownership interests rather than the property itself. Paid after senior debt.
3. Preferred equity — an equity interest with a stated preferred return and priority over common equity, but no lien.
4. Common equity — the sponsor and investors who own the upside. Paid last, and first to absorb losses.

Cash flow works down the list in that order each period; sale or liquidation proceeds do the same. The lower positions trade upside for protection, and the higher positions accept loss exposure in exchange for the residual.

Key distinction

Debt vs. preferred equity. Both may promise a fixed rate, but a lender holds a contractual right to repayment and a remedy — foreclosure — if payment is missed. Preferred equity typically holds a right to accrue an unpaid return and perhaps to take control of the sponsor's interest, not a claim on the property itself. The stated rates can look similar; the enforcement rights are not.

Priority vs. security. Being senior in the waterfall is not the same as being secured. Mezzanine debt sits above common equity in priority but may be secured only by equity interests, which is a materially weaker collateral position than a first mortgage.

Why it matters

The capital stack is the clearest way to understand the risk actually being taken in a private offering.

• Loss absorption. If a property loses 25% of its value, common equity in a deal financed 65% with senior debt can be substantially or entirely wiped out while the lender is repaid in full.
• Return expectations. Higher advertised returns in the same deal almost always come from a higher position in the stack, not from a better asset.
• Control. Loan covenants, cash-trap provisions and lender consent rights can override the sponsor's plans well before a default occurs.
• Cash-flow timing. A preferred return that accrues rather than pays currently can leave an investor with no distributions for years, even in a deal performing to plan.

Common misconceptions

• "Equity is safer because I own part of the building." Ownership is the residual claim. Debt holders are paid first from both income and sale proceeds.
• "A preferred return is guaranteed." Preferred means priority relative to common equity, not certainty. If cash flow is insufficient, the return typically accrues unpaid.
• "More leverage means better returns." Leverage magnifies outcomes in both directions and raises the break-even occupancy and exit price the deal must achieve.
• "The stack is fixed." Refinancing, capital calls, rescue financing and restructurings can reshuffle priority during the hold period; sponsors usually retain the right to make those changes.

Reading an offering with the stack in mind

Before evaluating projected returns, identify the position being sold, the total debt as a share of cost, whether preferred returns pay currently or accrue, whether the sponsor is contributing meaningful capital alongside investors, and what happens in a shortfall. Those five answers describe the actual risk more accurately than any headline return figure.

Practitioners distinguish the capital stack from the distribution waterfall. The stack sets legal priority; the waterfall sets how profits are divided within the equity layer, typically through preferred returns, catch-up provisions and promote or carried-interest tiers to the sponsor.

Documentation matters as much as the diagram. Intercreditor and subordination agreements govern what a mezzanine lender may do when the senior loan defaults; guaranty provisions determine whether recourse is limited to the asset or extends to the sponsor. In private placements sold under Rule 506, disclosure of these terms is contractual rather than prescribed by registration, so the operating agreement and loan documents — not the marketing deck — are the authoritative description of priority.