Capital Stacks in Commercial Property Financing

In commercial real estate finance, the capital stack is the legal organization of all the layers of debt that are used to purchase, build, or renovate a piece of real estate. The position of a piece of debt in a property’s capital stack determines what the order that lender will repaid in the case of a borrower default or bankruptcy. The general components of a real estate capital stack include:

• Equity: Funds directly placed in the project by owners/investors. Typically consists of a down payment between 20% and 30% for most projects. Equity investors are the last to be repaid if the borrower/borrowing entity declares bankruptcy.

• Preferred Equity: Equity in the project that effectively functions as debt. Preferred equity investors are paid a specific interest rate (often 10% or more), and generally participate in the upside of a project if it reaches a certain level of profitability (in the form of an equity kicker).

• Mezzanine Debt: Mezzanine debt is subordinate to a first or second position mortgage, and generally carries significantly higher interest rates (often between 9 - 16%). Most mezzanine debt has 5 - 10 year terms and is interest-only. Mezzanine loans usually occupy about 15% of a borrower’s capital stack. Mezzanine debt is similar to preferred equity, and mezzanine lenders and preferred equity investors both use shares in the borrowing entity as collateral.

• 2nd Position Mortgage: Technically, a second position mortgage is any mortgage that is subordinate to the primary mortgage, such as the mezzanine financing mentioned above. However, in other cases, a second position mortgage can take the form of a private money or hard money loan, which is especially popular for borrowers with credit or legal issues, or those who need to close especially quickly. The major difference most second position mortgages and mezzanine debt is the fact that most second position loans can actually secure a junior lien against the property instead of a lien against the borrowing entity.

• 1st Position Mortgage: The first position loan, or senior loan, is the primary loan on a commercial property, usually consisting of between 55% to 75% of the purchase price of the property. First position loans are secured by a first-position lien against the property, and  have first payment priority in the case of a bankruptcy. Only tax liens are superior in priority to a first-position lien on a commercial property.

While many commercial real estate projects may only have two layers in the capital stack, larger and more complex projects may have up to 4 (or even more) layers. However, most complex projects generally have 3 layers; owner equity, a mezzanine or junior loan, a first position mortgage.

What Happens to the Capital Stack if a Borrower Defaults?

If a borrower defaults on one or more of their mortgages, a variety of things may occur. If the default occurs on their mezzanine loan or their preferred equity, the mezzanine lender or preferred equity investors may take over the borrowing entity; however, to maintain control of the property, they will need to continue paying the first position lender, who may need to pay property taxes if they are not taken care of by the mezzanine lender or preferred equity investors. If the first position loan goes into default, the senior lender can attempt to foreclose on the property.

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Related Questions

What is the definition of capital stack in commercial real estate?

In commercial real estate finance, the capital stack is the legal organization of all the layers of debt that are used to purchase, build, or renovate a piece of real estate. The position of a piece of debt in a property’s capital stack determines what the order that lender will repaid in the case of a borrower default or bankruptcy. The general components of a real estate capital stack include:

• Equity: Funds directly placed in the project by owners/investors. Typically consists of a down payment between 20% and 30% for most projects. Equity investors are the last to be repaid if the borrower/borrowing entity declares bankruptcy.
• Preferred Equity: Equity in the project that effectively functions as debt. Preferred equity investors are paid a specific interest rate (often 10% or more), and generally participate in the upside of a project if it reaches a certain level of profitability (in the form of an equity kicker).
• Mezzanine Debt: Mezzanine debt is subordinate to a first or second position mortgage, and generally carries significantly higher interest rates (often between 9 - 16%). Most mezzanine debt has 5 - 10 year terms and is interest-only. Mezzanine loans usually occupy about 15% of a borrower’s capital stack. Mezzanine debt is similar to preferred equity, and mezzanine lenders and preferred equity investors both use shares in the borrowing entity as collateral.
• 2nd Position Mortgage: Technically, a second position mortgage is any mortgage that is subordinate to the primary mortgage, such as the mezzanine financing mentioned above. However, in other cases, a second position mortgage can take the form of a private money or hard money loan, which is especially popular for borrowers with credit or legal issues, or those who need to close especially quickly. The major difference most second position mortgages and mezzanine debt is the fact that most second position loans can actually secure a junior lien against the property instead of a lien against the borrowing entity.
• 1st Position Mortgage: The first position loan, or senior loan, is the primary loan on a commercial property, usually consisting of between 55% to 75% of the purchase price of the property. First position loans are secured by a first-position lien against the property, and have first payment priority in the case of a bankruptcy. Only tax liens are superior in priority to a first-position lien on a commercial property.

While many commercial real estate projects may only have two layers in the capital stack, larger and more complex projects may have up to 4 (or even more) layers. However, most complex projects generally have 3 layers; owner equity, a mezzanine or junior loan, a first position mortgage, and a second position mortgage.

What are the different types of capital in a commercial real estate capital stack?

The different types of capital in a commercial real estate capital stack include Equity, Preferred Equity, Mezzanine Debt, 2nd Position Mortgage, and 1st Position Mortgage.

Equity is funds directly placed in the project by owners/investors. Typically consists of a down payment between 20% and 30% for most projects. Equity investors are the last to be repaid if the borrower/borrowing entity declares bankruptcy.

Preferred Equity is equity in the project that effectively functions as debt. Preferred equity investors are paid a specific interest rate (often 10% or more), and generally participate in the upside of a project if it reaches a certain level of profitability (in the form of an equity kicker).

Mezzanine Debt is subordinate to a first or second position mortgage, and generally carries significantly higher interest rates (often between 9 - 16%). Most mezzanine debt has 5 - 10 year terms and is interest-only. Mezzanine loans usually occupy about 15% of a borrower’s capital stack. Mezzanine debt is similar to preferred equity, and mezzanine lenders and preferred equity investors both use shares in the borrowing entity as collateral.

2nd Position Mortgage is technically any mortgage that is subordinate to the primary mortgage, such as the mezzanine financing mentioned above. However, in other cases, a second position mortgage can take the form of a private money or hard money loan, which is especially popular for borrowers with credit or legal issues, or those who need to close especially quickly. The major difference most second position mortgages and mezzanine debt is the fact that most second position loans can actually secure a junior lien against the property instead of a lien against the borrowing entity.

1st Position Mortgage is the first position loan, or senior loan, is the primary loan on a commercial property, usually consisting of between 55% to 75% of the purchase price of the property. First position loans are secured by a first-position lien against the property, and have first payment priority in the case of a bankruptcy. Only tax liens are superior in priority to a first-position lien on a commercial property.

What are the advantages of having a capital stack in commercial real estate?

The advantages of having a capital stack in commercial real estate are numerous. First, it allows for a more efficient use of capital, as the different layers of debt can be used to finance different aspects of the project. For example, the first position loan can be used to finance the purchase of the property, while the mezzanine loan can be used to finance the renovation or construction of the property. Additionally, having a capital stack allows for more flexibility in terms of repayment, as the different layers of debt can have different repayment terms and interest rates. Finally, having a capital stack allows for more diversification of risk, as the different layers of debt can be held by different lenders, reducing the risk of default for any one lender.

How does the capital stack affect the return on investment in commercial real estate?

The capital stack affects the return on investment in commercial real estate in a variety of ways. The higher up in the capital stack an investor is, the higher the risk, but also the greater the potential rewards. On the other hand, the lower down in the capital stack an investor is, the lower the risk, but also the lower the potential rewards. If an investment performs well, the lender at the bottom of the capital stack generally won’t realize any additional return. If an investment performs poorly, the investor higher up in the capital stack is at risk when exiting an investment. For example, if a property is sold for less than the amount of the loan, the lender at the bottom of the capital stack will still get their cut, and the remaining money will pay out the next level of the capital stack. This could leave the investor higher up in the capital stack with nothing, unless the preferred equity layer is made whole.

What are the risks associated with a capital stack in commercial real estate?

In commercial real estate, the capital stack is a way to understand how much risk each level of capital has. Senior debt, which occupies the bottom — and often largest — layer, has the least amount of risk. If a borrower defaults on one or more of their mortgages, the senior lender can attempt to foreclose on the property. The mezzanine lender or preferred equity investors may take over the borrowing entity, but they will need to continue paying the first position lender. The actual property owner — often portrayed in the capital stack as the common equity — bears the greatest amount of risk, as any debt and preferred equity must be paid out first.

The risks associated with a capital stack in commercial real estate include:

• The senior lender bears some risk, as they may not get paid if the property sits empty.
• The mezzanine lender or preferred equity investors may take over the borrowing entity, but they will need to continue paying the first position lender.
• The actual property owner — often portrayed in the capital stack as the common equity — bears the greatest amount of risk, as any debt and preferred equity must be paid out first.

In this article:

1. Capital Stacks in Commercial Property Financing
2. What Happens to the Capital Stack if a Borrower Defaults?
3. Questions? Fill out the form below to speak with a commercial mortgage specialist.
4. Related Questions
5. Get Financing