A $50 million multifamily development with a $35 million senior loan leaves a $15 million financing gap. How that gap is filled, whether through mezzanine debt, preferred equity, additional common equity, or a combination, sets the project’s balance of risk, return, and control.
Beyond senior debt, three primary forms of capital typically fill that gap. Each sits at a different level of the capital stack and carries its own mix of security, return expectations, governance rights, and upside potential.
Here is how each layer functions and where it fits within a typical real estate capital structure.
Mezzanine Financing: The Subordinate Debt Layer
Mezzanine debt sits directly below senior debt but above all equity in the capital stack. Although it is classified as debt, it differs from senior financing in an important way: it is not secured by a mortgage on the property, but by a pledge of the borrower’s ownership interests in the property-owning entity. In a default, the mezzanine lender can foreclose on those equity interests under UCC Article 9, taking control of the entity more efficiently than a real estate foreclosure.
Key characteristics:
- Returns: Typically 11%–16% annually, structured as a combination of current pay, accrued interest, or payment-in-kind (PIK) interest, where unpaid interest is added to the principal balance instead of being paid in cash.
- Security: Secured by a pledge of ownership interests in the borrower entity, not the underlying property.
- Control provisions: Common covenants include approval rights over major decisions, restrictions on additional debt, and step-in or “springing” rights triggered by covenant breaches or performance issues.
- Tax treatment: Interest is generally deductible at the entity level, though subject to limits under Internal Revenue Code Section 163(j).
Common use cases:
Mezzanine financing is often used by sponsors seeking to reduce their equity investment without introducing a joint venture partner. It fits best in stabilized or near-stabilized assets with predictable cash flow and strong debt coverage. Because many senior lenders limit or prohibit subordinate debt, mezzanine loans usually require an intercreditor agreement outlining rights and remedies between lenders. When such debt is not allowed, preferred equity may serve as a substitute.
Preferred Equity: Structured Capital Below the Debt Line
Preferred equity sits below all debt in the capital stack but ranks ahead of common equity. Although it is classified as equity, it often functions like mezzanine debt by providing structured, contractual returns with defined distribution priorities.
The key distinction is that preferred equity is not debt. Because its payments are considered equity distributions rather than debt service, it typically avoids senior loan restrictions on subordinate financing, though lenders may still require consent if the preferred equity includes control rights or mandatory payments.
Key characteristics:
- Returns: Typically 12%–18%, structured as a priority return in the distribution waterfall. Some preferred equity also includes profit participation once certain return hurdles are met.
- Security: No collateral pledge or foreclosure rights. Investors rely on their contractual distribution priority and negotiated protective provisions.
- Control provisions: Can range from passive to active. Some preferred positions include step-in rights, approval over major decisions, or board representation tied to performance conditions.
- Payment flexibility: As equity rather than debt, distributions can be deferred, accrued, or capitalized during lease-up or construction, and later paid from refinancing or sale proceeds.
Common use cases:
Preferred equity is often used when senior lenders prohibit mezzanine financing or when investors seek more flexible terms than traditional debt provides. It works well for transitional, value-add, and development projects where early cash flow is uneven and patient capital is needed. Preferred structures are sometimes categorized as “hard pay,” requiring current distributions, or “soft pay,” allowing accrual until stabilization.
Common Equity: The Residual Ownership Layer
Common equity forms the foundation of the capital stack. It receives distributions only after all debt and preferred equity have been paid, absorbs losses first when performance falls short, and captures the majority of upside when a project outperforms.
This is where sponsors usually invest their own capital and where institutional joint venture partners participate when additional funding is needed.
Key characteristics:
- Returns: Performance-driven, often targeting 15%–25% IRR or higher. The sponsor’s carried interest, or promote, can significantly increase realized returns on successful projects.
- Risk profile: Bears first-loss exposure. In distressed situations where debt obligations cannot be met, common equity investors often lose their entire capital.
- Control and governance: Holds governance rights, voting power, and decision-making authority over key matters. In joint ventures, these terms are defined in the operating or partnership agreement.
- Upside potential: Unlimited. Once all senior claims are satisfied, all remaining cash flow and appreciation accrue to common equity holders.
Common use cases:
Common equity is an essential layer in every deal. The key question is the amount and source of that equity. Sponsors with available capital and high conviction often contribute a larger share to maintain control and maximize returns. When external equity is required, institutional joint venture partners can supply capital in exchange for shared governance and profit participation.
Capital Stack Structures in Practice
Revisiting the $50 million multifamily project with $35 million of senior debt, the remaining $15 million can be structured in several ways.
Structure A: Mezzanine-Heavy Approach
- $35M senior debt (70% LTV)
- $8M mezzanine debt (12% current pay)
- $7M common equity (sponsor and small co-investor)
This approach minimizes the sponsor’s equity contribution and benefits from tax-deductible interest on the mezzanine layer. However, it increases fixed payment obligations and reduces cash flow flexibility during operations.
Structure B: Preferred Equity Approach
- $35M senior debt
- $7M preferred equity (13% preferred return plus 10% profit participation above threshold)
- $8M common equity (sponsor-controlled)
This approach requires slightly more equity capital but allows greater operational flexibility. Preferred investors receive defined priority returns and limited profit participation, while the sponsor maintains control and decision-making authority.
Structure C: Pure Equity Approach
- $35M senior debt
- $15M common equity (50/50 institutional joint venture)
This structure removes subordinate capital altogether, maximizing flexibility and simplifying operations. The trade-off is shared governance and profit participation with an institutional partner.
Each option represents a different balance among leverage, control, flexibility, and return potential. The best structure depends on the project’s stability, senior loan restrictions, available sponsor capital, and desired level of control and upside.
Understanding the Trade-Offs
The decision between mezzanine debt, preferred equity, and common equity goes well beyond closing a funding gap. Each structure affects the project’s cash flow, control, and risk profile in distinct ways:
- Cash flow obligations: Fixed debt service versus priority distributions versus residual profits.
- Control and decision-making: Protective covenants versus negotiated step-in rights versus full governance control.
- Downside protection: Foreclosure rights versus distribution priority versus first-loss exposure.
- Upside participation: Capped returns versus shared profits versus unlimited appreciation potential.
The most effective capital stacks align structure with both the project’s fundamentals and the sponsor’s objectives. For stabilized assets with reliable income, mezzanine debt can provide efficient leverage. For value-add or transitional projects with uneven early cash flow, preferred equity offers useful flexibility. For high-risk development, partnering with a well-capitalized equity investor to share risk and upside is often most effective.
Understanding how these layers interact within the capital stack enables sponsors to structure financing that balances risk, return, and control in support of their investment thesis.