The four standard layers
From bottom (lowest cost, lowest risk) to top (highest cost, highest risk): senior debt, mezzanine debt, preferred equity, and common equity. Each layer sits in priority above the layer below it in the cash-flow waterfall, and below the layer above it in the foreclosure waterfall.
Senior debt typically funds 60%-75% of the capital stack. Mezzanine debt typically funds 5%-15% on top of senior. Preferred equity typically funds 5%-15% on top of mezz (or in place of mezz). Common equity funds the remainder.
How each layer is priced
Senior debt is the cheapest capital in the stack, typically 6%-9% all-in coupon depending on asset class, leverage, and lender type. Mezzanine debt typically prices at 12%-18%. Preferred equity typically targets 12%-18% IRR with a cash-pay component plus equity participation. Common equity typically targets 18%-25%+ IRR depending on the deal's risk profile.
The weighted average cost of capital across the stack determines the deal's overall return threshold. A stack with 75% senior at 7%, 10% mezz at 14%, and 15% common equity at 20% has a weighted average cost of approximately 9.7%. The deal needs to generate a return above this threshold to make economic sense.
Why structure matters
Two deals with the same total leverage can have very different cost-of-capital and risk profiles depending on how the stack is structured. Replacing common equity with preferred equity reduces the cost of capital (preferred is cheaper than common) but adds a contractual obligation. Adding mezzanine debt increases overall leverage but also adds debt service that constrains cash flow during the business plan.
Sponsors should optimize the stack around three goals: minimize the cost of capital, preserve flexibility on cash flow and exit, and align the structure with the senior lender's intercreditor requirements. Getting this right is what separates institutional sponsors from amateur ones.
Frequently asked questions
- What's a typical commercial real estate capital stack?
- A typical institutional commercial real estate capital stack is 65%-75% senior debt, 0%-15% mezzanine or preferred equity, and 20%-35% common equity. The exact mix depends on asset class, business plan, and sponsor objectives.
- Can a deal have both mezzanine debt and preferred equity?
- Yes, though it's less common. The combined senior + mezz + preferred equity total leverage typically can't exceed 85%-90% of cost, and the intercreditor arrangements between senior, mezz, and preferred get complex. Most deals use one or the other, not both.
- Why is common equity the most expensive capital?
- Common equity is last in line in both the cash-flow waterfall and the foreclosure waterfall, it bears the most risk and therefore demands the highest return. The target IRR for common equity (typically 18%-25%+) reflects this risk premium.
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