A clear capital stack shows who gets paid, who controls decisions, and who absorbs losses in a real estate private equity deal. Think of it as a contract-driven order of priority that allocates cash flow, sets remedies when things go off plan, and clarifies who can act in a downturn so execution stays predictable.
In practice, the stack is more than a diagram. It is the product of loan agreements, joint venture provisions, collateral packages, and entity design. When you assemble these parts correctly, you gain certainty of closing and a faster path to recover value if performance slips.
The capital stack in plain English
Most deals layer funding from safest to riskiest: senior mortgage debt, mezzanine debt, preferred equity, then common equity. Labels do not control outcomes. Contracts, collateral, and intercreditor terms do. For background on the broader context of real estate private equity, start with the fund model and how sponsors raise and deploy capital.
- Senior mortgage debt: First lien on the property, paid first from cash and sale proceeds.
- Mezzanine debt: Pledge of equity in the property-owning borrower, behind the mortgage but ahead of equity.
- Preferred equity: Contractual preferred return with negotiated control rights, but no lender claim on collateral.
- Common equity: Residual owner that captures upside after every other layer is satisfied.
Structures often splice layers with hybrids. A or B notes divide senior risk internally. Pari passu tranches share the senior position across lenders. Ground leases can bifurcate fee and leasehold economics. The specific mix shapes control and recovery, which in turn affects the cost of capital.
Stakeholder incentives and control levers
Every participant sees the same rent roll differently because incentives diverge. This alignment check is your first underwriting pass.
- Senior lenders: Prioritize payment certainty and collateral recovery. They push for cash management, strong guarantors, and early-warning covenants. In exchange, they offer lower rates and greater closing certainty.
- Mezzanine lenders: Prefer quick remedies and tight performance tests at the equity pledge level. They rely on intercreditor agreements to keep rights meaningful. For a refresher on how mezz works, see Mezzanine Financing in Real Estate.
- Preferred equity: Prices to foreclosure or control risk while seeking equity tax and reporting. It negotiates springing control and buy-sell rights to step in if performance underwhelms.
- Common equity: Targets total return and flexibility to pivot the plan, accepting the risk of being last in line.
When in doubt, ignore labels and read the intercreditor and recognition agreements first. They reveal who can act, on what timeline, and with what limits.
Entity design and ring-fencing for resilience
Most sponsors hold the asset in a bankruptcy-remote single purpose entity, often a Delaware LLC or LP, to insulate the property from other liabilities. Senior lenders require separateness covenants, independent directors, and tight limits on new debt or transfers. Opinion letters backstop non-consolidation and authority, which lowers the senior loan spread.
Mezzanine lenders secure the equity of the mortgage borrower under the Uniform Commercial Code and can foreclose by selling the pledged equity in a commercially reasonable process. In New York, a UCC sale can conclude in weeks or months if properly noticed, which is much faster than a typical judicial mortgage foreclosure.
Preferred equity sits inside the joint venture agreement of the property owner. It uses springing control, manager replacement, and buy-sell mechanisms, anchored by a lender recognition agreement to avoid tripping mortgage transfer or change-of-control covenants during an exercise of remedies.
How cash flows through the waterfall
Cash usually funnels into a lender-controlled lockbox with triggers based on debt service coverage ratio, loan-to-value, or debt yield. When tests trip, cash sweeps activate and reserves grow. This creates early warning and control for lenders while preserving funds for taxes, insurance, capital expenditures, and leasing.
- Senior waterfall: Pays servicing fees, protective advances, current interest and scheduled principal, then replenishes reserves before any excess is released.
- Mezzanine position: Receives its distributions only after the senior is current and within intercreditor limits that set standstills and cure rights.
- Preferred equity: Collects its current pay and accruals after all debt service and reserves, then returns capital and shares residuals per the JV agreement.
- Common equity: Takes what is left after preferred is current or redeemed, with catch-ups or IRR hurdles shaping the sponsor’s promote.
Because many loans are interest only, understanding coverage is critical. If you need a quick refresher on the math, review Debt Service Coverage Ratio for CRE.
Collateral, guarantees, and remedies that actually work
Senior lenders perfect a first-priority mortgage or deed of trust, a security interest in accounts and personal property, and an assignment of leases and rents. Guarantees often include completion, carry, and environmental. Limited recourse carveouts convert to recourse upon bad acts such as voluntary bankruptcy, fraud, misappropriation, or separateness breaches. Draft springing recourse carefully to avoid unintended full recourse.
Mezzanine lenders take a pledge of the borrower’s equity and related distributions. Remedies include exercising voting rights, replacing the manager, and foreclosing on the equity via UCC sale. These steps must be recognized under the intercreditor agreement so they do not trigger a mortgage default beyond negotiated limits.
Preferred equity relies on contract rights: step-in control, forced sale or refinance, manager replacement, and buy-sell mechanisms. A recognition agreement ensures these actions do not breach mortgage transfer limits when conditions are met.
Consent and information rights by layer
- Senior lenders: Consent for additional debt, transfers, major leases, material contracts, manager changes, and off-budget capex. Receive monthly operating statements, rent rolls, and quarterly plus audited annual financials.
- Mezzanine lenders: Mirror many senior consents through the intercreditor agreement, including budgets and affiliate transactions. Receive property-level reporting, sometimes with a lag.
- Preferred equity: Joint venture consents for plan changes, financings, large contracts, settlements, and tax elections, with inspection and step-in rights on default.
Documentation you will close every time
- Senior mortgage loan: Mortgage or deed of trust, loan agreement, notes, assignment of leases and rents, guaranties, security agreement, cash management, cap assignment, and legal opinions. Diligence includes organizational documents, title and endorsements, survey, zoning, property condition, and environmental reports.
- Mezzanine loan: Mezzanine loan agreement, pledge and security agreement, promissory note, deposit account control, intercreditor agreement, and UCC filings.
- Preferred equity: Amended and restated JV or LLC agreement, lender recognition, governance and reporting side letters, and required consents.
- Hedging: ISDA Master Agreement with Schedule, Credit Support Annex, and a cap confirmation. Senior lenders require cap assignment and counterparty credit standards or cash collateral if downgraded.
- Closing order: Close senior first to perfect the first lien, then mezzanine, then preferred. Execute intercreditor and recognition agreements before funding any subordinate capital.
Economics and fee stack
Senior loans can be fixed or floating, with floating often priced at SOFR plus a spread. Interest rate caps protect coverage and must match the loan’s extension profile. Amortization is frequently interest only during the plan, with extensions tied to coverage tests. Prepayment protections range from yield maintenance to defeasance or fees, and expect origination and ongoing servicing costs.
Mezzanine is typically floating and interest only, combining current pay and PIK with origination and exit fees. Covenants track coverage and asset milestones. Transfer and make-whole terms usually echo the senior loan.
Preferred equity establishes a current preferred return, accrues unpaid current, then repays capital before splitting residuals. During construction, a PIK feature may flip to current at stabilization. Governance protections often parallel mezzanine, compensating for the lack of collateral.
Common equity carries the promote. Sponsors generally earn their carry after investor capital and preferred returns are satisfied, with deal-by-deal catch-ups. Debt triggers can pause distributions, aligning optics under stress.
Numerical walk-through
Assume a $100 total cost. Senior mortgage at 55 percent loan-to-cost priced at 7 percent with a 1 percent origination fee. Mezzanine at 10 percent with a 12 percent all-in and a 1.5 percent origination fee. Preferred equity at 15 percent with a 12 percent current and 2 percent accrual if unpaid. Common equity at 20 percent.
If stabilized NOI reaches $8.0 by year 3, year 1 current interest equals $3.85 on the senior, $1.2 on the mezz, and $1.8 to preferred. About $1.15 remains for reserves and any common distribution. If the asset sells at $110 in year 4 with $1.0 costs, proceeds first pay senior and mezz at par, then redeem preferred with any accrued amounts, and finally flow to common. Preferred returns depend on hold length and pay-in-kind accruals. Common IRR moves most with timing and stabilization pace.
Accounting, reporting, and tax considerations
At the fund level, many real estate private equity vehicles qualify as investment entities and mark to fair value under US GAAP or IFRS. Others consolidate variable interest entities and account for joint ventures under the equity method. Property-level borrowers consolidate subs, expense interest unless capitalized to construction, and apply modern lease accounting to tenant incentives and straight-line rent. Classify preferred equity consistently based on redemption and return terms to avoid unintended covenant or tax effects.
Tax structures typically rely on partnerships or LLCs taxed as partnerships to pass through income and depreciation. Foreign and tax-exempt investors often use blockers or REITs to manage effectively connected income and withholding. Section 163(j) limits interest deductions unless a real property trade or business election is made, which trades interest deductibility for longer depreciation lives. Pay attention to original issue discount and PIK accruals that create cash-tax mismatches, and validate qualification for portfolio interest to reduce withholding on cross-border loans.
Regulatory items to track now
US managers remain subject to the Advisers Act, amended Form PF reporting, and core custody, advertising, and recordkeeping rules. The Fifth Circuit vacated the SEC’s 2023 private fund adviser rules, but examination risk persists. FinCEN’s beneficial ownership rule effective January 1, 2024 requires many single purpose entities to report owners and applicants unless exempt, so align KYC and sanctions screening with the new standards. In the EU, AIFMD II adjusts delegation, liquidity risk, and loan-originating fund rules, with national regimes governing non-EU marketing.
Key risks, edge cases, and a 2-minute audit
- Cash control slippage: If lockboxes and springing cash management are not activated as documented, cash can leak. Test account control and servicing before funding.
- Structural subordination: A mezz pledge at one holdco can end up behind preferred equity at another tier. Map every entity and pledge up front.
- Intercreditor deadlocks: Vague standstill and cure terms stall mezz actions while senior moves. Negotiate objective triggers and clocks.
- UCC foreclosure defects: Poor notice or sale procedures invite challenge. Pre-negotiate sale mechanics and data room access.
- SPE covenant breaches: Commingling or cross-defaults can trigger recourse. Operationalize separateness in property management and accounting.
- Hedging gaps: Counterparty downgrades or cap expiry before loan maturity can threaten extensions. Track replacements and escrow triggers.
- Preferred recharacterization: Fixed returns with mandatory redemption may be treated as debt. Align legal and tax treatment early.
- Construction slippage: Cost overruns and lien priority issues erode collateral. Use GMP contracts, payment bonds, and robust completion guarantees.
- Transfer traps: Internal sponsor moves can breach loan or tax rules. Plan within consent limits and qualified transferee definitions.
Fast diagnostic you can run today
- Map dollars: Tie every dollar to its security, consent rights, and remedy. If two layers claim the same cash first, you have a dispute waiting to happen.
- Time the remedies: If a remedy requires someone else’s consent or a long notice period, haircut its value in your model.
- Stress tests: Run coverage and value stresses with cash sweeps on. If you cannot meet extension tests under plausible forward curves and cap strikes, the plan is at risk.
- Governance clarity: If recognition or intercreditor language is light, price for delay, not just probability of default.
Variants and adjacent structures
- CMBS and SASB: Conduit CMBS slices senior risk into rated tranches while SASB finances larger single assets or portfolios. Standardized documents increase servicer control and reduce borrower flexibility.
- Ground lease bifurcation: Fee owners lease land to a leasehold borrower, lowering loan-to-fee exposure and shaping practical senior and junior positions via recognition and cure rights.
- A or B notes and participations: Lenders split one mortgage into senior and junior pieces or share pari economics via participations, with control allocated by agreement.
- NAV loans: Fund-level credit against a pool of investments provides liquidity without property-level leverage. It sits senior to GP distributions but junior to property-level debt.
For a broader view of how fund structures create and share value, see how real estate private equity funds generate returns and how structures and fees differ by strategy. If you need a quick definition on any term, consult this glossary.
Implementation timeline and owners
- Weeks 0-2: Design the stack, align term sheets, and synchronize the model across senior, mezz, and preferred. Select a cap provider and confirm tax structure.
- Weeks 2-6: Draft documents, run title and property diligence, negotiate intercreditor and recognition agreements, and secure credit approvals and hedges.
- Weeks 6-8: Finalize covenants, cash management, reserves, independent directors, and opinions. Complete beneficial ownership and KYC checks and lock the closing sequence.
- Closing: Record liens, fund in order, execute ISDA and cap assignment, fund reserves, and activate the lockbox. Deliver post-closing recordings and UCC confirmations.
- Post-closing: Establish monthly reporting, map DSCR and debt yield triggers, track cap maturities, and prepare for audits and valuations consistent with fund policies.
Underwriting the stack and what it is not
Underwrite priority by reading enforcement mechanics, not pitch decks. Price each layer to the clarity of its control and the speed of its remedy. Debt compresses when governance is tight and collateral is sound. Mezzanine and preferred widen when recognition rights are thin or procedures are slow. Sponsors should budget more for optionality. Lenders and preferred investors should price to procedure and time, not just nominal rank.
Finally, the capital stack is not a guarantee. Courts can recharacterize instruments, consolidate entities, or allow debtor-in-possession financing that primes unsecured claims. Tax authorities can look through form. The outcome depends on documents and day-to-day discipline, not diagrams.
Key Takeaway
Design your capital stack to make performance straightforward and underperformance survivable. Map cash, control, and timing with the same rigor you apply to rent rolls and cap rates. When rights are clear and remedies are fast, pricing tightens, closings stick, and recoveries improve.