The capital stack is the structure of financing that funds a real estate development project, the layers of debt and equity, from the most senior (first to be repaid, lowest risk) to the most junior (last to be repaid, highest risk). Understanding how the capital stack is structured, what each layer costs, and what controls each capital source exercises over the project is foundational knowledge for developers entering the market and useful context for anyone, lender, investor, construction manager, who works on projects whose financing they don’t directly control.
The Basic Structure
A typical development capital stack has three to five layers, depending on the project’s complexity and the financing market’s current conditions. From most senior to most junior:
Senior debt (the construction loan). The construction loan is the largest single component of most capital stacks, typically 55% to 75% of total project cost. The construction lender holds a first mortgage on the property, meaning they are the first creditor to be repaid if the project is sold or refinanced, and the first creditor to foreclose if the loan defaults. Because the construction lender holds the first position, they accept the lowest risk of any capital source and accordingly charge the lowest cost of capital, typically a floating rate of SOFR plus 200 to 400 basis points for conventional bank construction loans in 2024.
The construction loan is structured as a draw facility, funds are disbursed in draws as construction progresses and verified by inspection, rather than in a lump sum at closing. The draw structure is the mechanism that allows the lender to monitor construction progress and control disbursement risk throughout the construction period.
Mezzanine debt. Mezzanine financing fills the gap between the senior debt maximum and the equity the developer can contribute. A mezzanine lender holds a second position, behind the senior debt lender in the repayment priority, and accordingly charges substantially higher interest: typically 8% to 14% in 2024 market conditions, sometimes with additional fees or equity participation.
Mezzanine debt is not always present in a capital stack. When a developer has adequate equity, or when the senior lender’s loan-to-cost ratio is high enough to cover most of the project cost, mezzanine is unnecessary. When the developer’s equity is limited and the gap between senior debt and total project cost is significant, mezzanine fills the gap rather than requiring the developer to raise more equity.
Preferred equity. Preferred equity sits between mezzanine debt and common equity in the priority waterfall. Unlike mezzanine lenders, preferred equity investors do not hold a mortgage position, they have contractual rights to preferred returns and priority distributions that are junior to all debt but senior to the common equity. Preferred equity typically costs 10% to 18% and is used in project structures where mezzanine is not available or where the developer’s control structure makes mezzanine problematic.
Common equity. Common equity is the developer’s own investment, the capital that funds the gap between total debt (senior plus mezzanine or preferred) and total project cost. Common equity is the last capital in and the last to be repaid. If the project encounters cost overruns, schedule delays, or market softening, the common equity absorbs the losses first. Because common equity carries the highest risk, it requires the highest return, typically 15% to 25% or more depending on the project type and market.
In many projects, common equity is split between the developer’s general partner (GP) equity, a small percentage of the total equity from the developer, and limited partner (LP) equity from outside investors who provide most of the equity capital in exchange for a preferred return and a share of profits.
What Each Layer Controls
The capital stack is not just a financing structure, it is a control structure. Each capital source negotiates rights that reflect the risk it is taking.
The senior lender controls the draw process, no money moves without the lender’s approval, and holds the right to accelerate the loan and foreclose if the project defaults. The senior lender’s construction loan monitoring program (draw inspections, cost-to-complete analysis) is the mechanism through which they exercise that control.
Mezzanine lenders typically negotiate intercreditor agreements with the senior lender that define when the mezzanine lender can exercise remedies, whether they have a cure right if the senior loan defaults, and how the two creditors interact if the project goes into distress. Mezzanine lenders also negotiate control rights that may include the right to replace the GP if the project’s performance falls below agreed thresholds.
Preferred equity investors negotiate distribution waterfalls, the contractual priority in which cash flows and sale proceeds are distributed, and often negotiate governance rights that allow them to remove the GP or force a sale if preferred returns are not being met.
Common equity (the developer) controls day-to-day project management within the constraints that the senior lender, mezzanine lender, and preferred equity investors have negotiated. The developer’s control rights narrow as the project’s leverage increases and as the capital stack includes more layers of structured financing.
How the Stack Affects Development Decisions
The capital stack’s structure affects every significant development decision, which lender to use, how to size the project, how to manage construction costs, and when to sell or refinance.
A developer who understands the waterfall, the order in which all capital sources are repaid when the project generates revenue or is sold, can make better decisions about when to accept a mezzanine lender’s terms, when preferred equity makes more sense than mezzanine, and how the return structure affects the economics of the project for the developer versus the outside investors.
The construction management and owner’s representative function exists within the capital stack’s control structure. Understanding who controls the construction draw process, what reporting is required at each level of the stack, and what conditions trigger control rights at the mezzanine and preferred equity levels is practical knowledge for anyone managing construction on a project with complex financing.
Innergy Integral provides these services in Austin, TX and across our six-state footprint.
Related: Multifamily Construction Loan Structure · Multifamily Lender Selection · Construction Loan Monitoring · Development Advisory Guide
Markets: Multifamily Development Seattle WA · Multifamily Development Dallas TX · Multifamily Development El Paso TX