• Common Equity:
At the top of the capital stack is common equity. This represents the ownership interest in a property and is typically provided by the sponsors or equity investors. Common equity holders are the last to receive any distributions and are the first to absorb any losses the property may generate. Due to this high level of risk, common equity investors expect higher returns. These returns come in the form of property appreciation and cash flow distributions after all the other obligations of the property are met.


• Preferred Equity:
Preferred equity sits below common equity in the capital stack. Preferred equity investors have a superior claim on cash flows compared to common equity holders, but are subordinate to the debt that encumbers the property. They receive fixed, often higher, returns than common equity holders, but still face the risk of losing their investment if the property underperforms. They are generally paid before common equity holders in the event of liquidation.


• Mezzanine Debt
Mezzanine debt bridges the gap between senior debt and equity. It is typically used when a borrower requires more capital than what the senior lender is willing to provide, but does not want to dilute ownership by issuing more equity. Mezzanine lenders often take a higher interest rate compared to senior debt to compensate for the increased risk. In case of default, mezzanine lenders can convert their debt into equity and take over the property if necessary.


• Senior Debt
Senior debt is the cornerstone of most commercial real estate capital structures. This is the first layer of debt secured by the property and has the highest priority in terms of repayment. Senior lenders, usually banks or institutional lenders, provide the majority of the financing and typically offer the lowest cost of capital due to their lower risk exposure. In the event of default, senior debt holders have the first claim on the property’s assets.


• Sponsor Equity
Sponsor equity is the capital that the sponsor (or developer) invests into the project. This equity aligns the sponsor's interests with those of the other investors, as the sponsor has a financial stake in the success of the project. Sponsor equity is usually part of the common equity, but it may have its own distinct position depending on the deal structure.

• Risk and Return
Each layer of the capital stack comes with a different risk and return profile. Senior debt is the least risky and typically offers the lowest returns, while common equity is the most risky and offers the highest potential returns. Investors must understand their position in the capital stack to align their risk tolerance and investment objectives appropriately.


• Control and Decision-Making
The position in the capital stack also influences control and decision-making in a project. Equity investors, especially common equity holders, often have a say in major decisions regarding the property, while debt holders have more control in scenarios involving default or restructuring.


• Project Feasibility
For investors, developers and sponsors, structuring the capital stack effectively can determine the financial feasibility of a project. The blend of debt and equity affects the cost of capital and the overall return on investment, influencing whether a project is able to move forward.

Conclusion
The commercial real estate capital stack is a layered structure representing different sources of financing, each with its own risk, return and level of control. By understanding the intricacies of the capital stack, investors, developers and lenders can make carefully informed decisions, effectively manage risk and thereby optimize the returns on their commercial real estate investments. Whether you're an equity investor seeking high returns or a lender prioritizing security, recognizing your position within the capital stack is essential for successful investment in the commercial real estate market.