The most expensive money in your real estate deal is not the bank. Bold statement? Maybe. But stick with me.
The bank charges you five, six, seven percent. Your equity investors? They're costing you twenty. And if that math surprises you, this is going to change how you finance every deal you do from here on out.
I'm working on a project right now where the developer's capital stack has ten different sources of capital in it. Ten. And how you stack that money, the order it goes in, and who gets paid first decides your returns just as much as the actual property does. If you're serious about commercial real estate investing, this is the framework that separates deals that pencil from deals that don't.
In This Article
What the Capital Stack Actually Is
The Capital Stack, By the Numbers
4 Layers
Senior debt, mezzanine, preferred equity, common equity
60-65%
Typical senior debt cap today, limited by DSCR
~20%
What common equity costs, versus 7% for the bank
What the Capital Stack Actually Is
The capital stack is the foundation of every deal you do. It's simply the debt and the equity in a project, stacked in order of who gets paid back first.
It can be as simple or as complicated as you want. If you're paying all cash, your capital stack is one layer. Done. But if you're doing something like an affordable housing development, it gets wild. I'm selling some land right now to an affordable housing developer whose stack already has ten sources of capital in it, and they're probably looking at eleven or twelve by the time it's done. You can imagine underwriting a deal like that gets complicated fast.
Here's the one principle that runs the whole thing: the lower a layer sits in the stack, the more secure it is, the cheaper it is, and the sooner it gets paid back. The higher you go, the more risk, the more it costs, and the longer it waits. Every dollar in your deal comes from one of these layers.
Layer 1: Senior Debt (The Cheapest Money You'll Get)
Senior debt is the bottom of the stack. This is your traditional bank loan, and it's the cheapest capital you're going to find, because the lender takes first position on the property. If everything goes sideways, they get paid back first. That security is exactly why they charge you less.
Today, senior debt is landing somewhere in the six and a half to seven and a half percent range. When I ask a room full of investors what they're seeing, I hear everything from 6.25% up to 7%, and a lot of it depends on the asset and the market.
But here's what's changed. It used to be that loan-to-value was the number that mattered. You'd walk in expecting 75 or 80%. Banks will still tell you "we'll give you 80% loan-to-cost," and then the term sheet shows up at 65%. Why? The debt service coverage ratio. That, more than anything, is what limits how much debt you can actually put on a property today.
Most lenders want to see a 1.2 to 1.25x DSCR, which just means they want you making a dollar and a quarter for every dollar of debt service. It's a simple calculation: take your net operating income and divide it by the ratio. That's one of the first numbers I run on a deal, because it tells me how much debt the property can carry before loan-to-value even enters the picture. Right now that's pushing a lot of senior debt down to 60 to 65% of the deal.
And that's not a bad thing. Your bank is the biggest partner in your deal. They look at these things all day. If they're pulling back, there's usually a reason, and it's worth having the conversation to find out why.
Layer 2: Mezzanine Debt (The Gap Filler)
Sitting on top of senior debt is mezzanine, or junior, debt. It doesn't have to come from a bank. It's often a private lender. But here's the critical part: your mezzanine debt almost always has to be approved by your senior lender.
There are people out there teaching investors to quietly stack extra debt on a property after closing so nobody finds out. I'm sure some of you know exactly who I'm talking about. That violates about 99% of the loan covenants I've ever seen, and your senior lender can call the note and foreclose the moment they find out. Don't do it. Get it approved.
Mezz debt takes second position, which means it gets paid back after the senior lender. It's more expensive because of that added risk, and it's a tool I only reach for in one situation: filling the gap between what the senior lender will do and what I've got for a down payment.
Say the bank comes in at 65% and you've only got 25% to put down. A 10% slice of mezz debt can fill that gap without you having to raise more equity. It's most common in ground-up development, where lenders cap their senior loans lower because of the risk.
"Mezz debt is like an axe. If you've got a sharp axe and you know what you're doing, you can take down a tree. If you don't, you can take off your foot."
- Tyler Cauble
Layer 3: Preferred Equity (The Hybrid)
Preferred equity is one of my favorites, and it's a strange one, because it behaves like debt but it's technically equity.
It counts toward your down payment, so it's not debt on the balance sheet. But the preferred equity investor gets to act like a debt partner. They get paid before your common equity, often at a set rate that can either be paid out of cash flow or accrue and get paid at the end. Only after they've gotten their return do you and your common investors start to split anything.
The trade-off is that they take a smaller piece of the upside than common equity would, because they're getting that more secure, interest-like payment along the way. It's a real hybrid, and honestly I'd take well-structured preferred equity over mezz debt any day.
The mistake I see is preferred equity investors who want it both ways: mezz-lender interest rates and a big chunk of the upside. That doesn't make sense. Structure it right and it's one of the most flexible tools in the stack.
Layer 4: Common Equity (The Most Expensive Money in the Deal)
At the top of the stack is common equity. This is what most of us picture when we say "equity": your down payment, your cash, your investors.
It gets paid last, which is exactly why it costs the most. Common equity takes the most risk in the deal, so it earns the most reward. When we're underwriting, we're often targeting around a 20% annualized cash-on-cash return for that equity, versus the 7% we're paying the bank.
So why pay equity 20% when the bank is 7%? Because equity is patient. It doesn't need to get paid every month. It's willing to wait and take the risk that the deal works out. That patience is worth a premium.
This is also where your investor structure lives. When I raise capital for a deal, I keep it simple. My splits usually run between 70/30 and 80/20 depending on the business plan. We'll charge a 1 to 2% acquisition fee, a 1 to 2% asset management fee, and a half-percent disposition or refinance fee. Investors get a preferred return, usually around 8% on their contributed capital, and then it's a pari passu split after that. That means the first chunk of profit goes to investors until they've hit that 8%, and then we split based on the equity split.
I don't do complicated waterfalls. I've got professional athletes who invest with us. They hit their heads a lot, and none of us want to get lost in the math. A clean, clear waterfall makes it easier to raise capital every single time, because your investors already know your formula.
Why Not Just Stack All Debt?
Here's the tempting question: if equity is the most expensive money in the deal, why wouldn't I just pile on as much cheap debt as possible and make more?
Two reasons. First, the DSCR won't let you. The bank caps your leverage based on how much income the property throws off. Second, the more leverage you pile on, the more fragile the deal gets. One bad month and you're underwater.
The real move isn't maximizing debt or minimizing equity. It's engineering your blended cost of capital. You want to structure the stack so the average cost of all your money, weighted across every layer, is as low as you can reasonably get it, because that's what leaves the most upside for you.
At our mastermind, I hand the room a $3 million mixed-use deal doing $195,000 in NOI at a six and a half percent cap rate. The bank will only lend 65%. Their job is to fill the gap and get the blended cost of capital as low as possible. Some fill it with all equity and watch their returns shrink. The ones who win layer in the right mix of mezz debt or preferred equity to keep that blended number down.
The Part Nobody Talks About: Just Go Find the Money
Structure matters. But so does effort. When I ask people how many banks they've talked to and they say "three, and they all said no," that's not a dead deal. That's not enough phone calls.
When I financed Salt Ranch, our boutique hotel in East Nashville, I talked to 50 banks. Fifty. A lot of them told me the exact same deal with a Holiday Inn flag on it would've been an easy yes. But I didn't want to flag it, and banks see an unflagged boutique hotel as a riskier asset. So I kept dialing until I found the lender who got it.
We pitched that deal to investors at a 24% IRR target and close to a 3x equity multiple, with a 60/40 LP/GP split because of the added risk and the operating business behind it. None of that happens if I quit at bank number five.
And don't forget how flexible seller financing can be. A seller can carry a piece as senior debt, as mezz debt, even as preferred equity. I've seen sellers finance nearly the entire stack while the buyer brings a small slice of equity. If you get creative, there's almost always a way to structure a deal with very little of your own money down.
Key Takeaways
The capital stack is priced by risk. Senior debt is cheapest because it's first in line. Common equity is most expensive because it's last.
DSCR, not loan-to-value, sets your leverage today. Run it early. Most senior debt is capped at 60 to 65%.
Use mezzanine debt only to fill a gap, and get it approved by your senior lender. It's a sharp axe.
Preferred equity is the flexible hybrid. Structured right, it can beat mezz debt.
Engineer your blended cost of capital, and make far more phone calls than you think you need to.
This article is adapted from a session at our CRE Central mastermind on the Tyler Cauble YouTube channel.
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