Capital stacks in commercial real estate financing often go beyond traditional senior loans. To close funding gaps or enhance returns, developers and investors frequently turn to mezzanine debt, preferred equity, or common equity. Each of these sources plays a distinct role, with varying implications for control, repayment priority, and risk exposure.
Let’s break down how they differ and where each fits within a capital structure.
Mezzanine Financing
Mezzanine financing sits just below the senior loan in the capital stack. It’s technically debt, but instead of being secured by the real estate itself, it’s backed by a pledge of the borrower’s equity interests in the property-owning entity.
Key features of mezzanine debt:
- Position: Subordinate to senior debt, but senior to all equity.
- Returns: Typically 9%–14%, via current and/or deferred interest.
- Security: Collateralized by a pledge of equity, not the asset.
- Control rights: May include the ability to take over ownership if the borrower defaults.
- Use case: Ideal for borrowers who want to reduce the amount of equity they need to contribute without taking on a full joint venture partner.
Mezzanine lenders are often institutional investors or specialty finance companies comfortable with higher risk in exchange for a structured, reliable return.
Preferred Equity
Preferred equity is an increasingly popular alternative to mezzanine debt. While it sits below all debt in the capital stack, it often behaves like structured debt, with predictable returns and predefined repayment mechanics.
What sets preferred equity apart:
- Position: Subordinate to all debt but senior to common equity.
- Returns: Typically 9%–15%, with fixed payments and sometimes a back-end share of profits.
- Control rights: Vary based on structure, can range from minimal oversight to significant influence, including step-in rights.
- Use case: Helpful when a senior lender doesn’t allow mezzanine debt or when sponsors want to preserve full ownership of the property.
Preferred equity is especially flexible. Sponsors can negotiate terms that strike a balance between control and capital efficiency.
Common Equity or Joint Venture Equity
Common equity represents the ownership interest in a project. This is where true upside potential lies, but also the greatest risk. Common equity holders are last in line when it comes to distributions, but they benefit the most when a project performs well.
Typical attributes of common equity:
- Position: Last in the capital stack, paid only after debt and preferred equity.
- Returns: High variability, often 15%–25%+ IRR depending on deal performance.
- Control rights: Usually includes governance rights and voting power, especially in joint venture arrangements.
- Use case: Provided by the sponsor or equity investors to cover the remaining funding after debt and structured finance are in place.
In many cases, common equity participants share both the decision-making and profit upside in a way no other party does.
Putting It All Together
Here’s a simple comparison:
|
Feature |
Mezzanine |
Preferred Equity |
Common Equity |
|---|---|---|---|
|
Capital Stack |
Below senior debt |
Below mezzanine, above equity |
Bottom of the stack |
|
Return Range |
9%–14% |
9%–15% |
15%–25%+ (variable) |
|
Security |
Equity pledge |
Structured return |
Ownership interest |
|
Control |
May take over equity |
Varies; may have control rights |
Governance + voting |
|
Risk Level |
Medium |
Medium–High |
High |
|
Upside |
Limited |
Moderate (some profit share) |
Unlimited |
Final Thoughts
A well-structured capital stack can significantly impact both project outcomes and investor returns. Understanding where mezzanine, preferred equity, and common equity fit into the equation can help sponsors choose the right partners and the right strategies for their deals.
At i95 Capital, we help commercial real estate sponsors navigate and structure these layers to meet their financing goals efficiently. Whether you’re building from the ground up or refinancing an existing asset, we can help you access the capital you need to move forward.
Looking to finance your next CRE deal? Contact us to learn about the capital options available to you.
