Capital stack

A project’s capital stack shows the layers of capital invested in it. This includes debt and equity, as well as hybrid instruments that share features of both.

capital stack

The layers represent levels of seniority, that is, in terms of who gets paid back first. The stack shows the riskiest positions at the top and safest at the bottom. Investors in the upper levels expect higher returns to compensate for that higher risk. Because the project has to pay back debt holders first, their risk is lower and thus they accept lower returns on their investments.

The Complete Real Estate Encyclopedia, arranges the stack this way, from top to bottom:

  1. Sponsor equity.
  2. Preferred equity.
  3. Mezzanine investors (hybrid debt and equity).
  4. Second and other junior mortgages.
  5. Investment-grade first mortgages.

Capital stack elements

The top and bottom of the capital stack are fairly straightforward. Sponsor equity is common equity applied specifically to real estate projects.

Investment-grade first mortgages are property value-backed debt instruments. If the project falls through, project sponsors would sell the property. Subsequently, they would pay off the mortgage issuer first.

At this point, who receives payment next becomes a little more complicated. What makes some debt junior to other debt is its lesser priority to other claims. (Incidentally, the more formal name for capital at this layer is subordinated debt.) In case of liquidation, management would pay back the junior debt  only after satisfying the senior debt. A second mortgage is typically junior to a first mortgage. Still, it’s just as much a mortgage and property value backs it up as well.

Like credit card debt, the full faith and credit of the project sponsors, and nothing else, backs up the mezzanine level.

Preferred equity is a hybrid resembling both equity and debt. Although preferred shareholders are junior to all lenders, they are senior to common shareholders. This has other implications beyond getting money out in the event of liquidation. Preferred equity generally comes with guaranteed dividends, similar to the interest payments that bondholders receive. Common equity, on the other hand, often comes with dividends, but management doesn’t guarantee them. The project would have to pay the guaranteed dividends to the preferred shareholders before setting money aside to pay dividends to the common shareholders.


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