The capital stack, layer by layer

Every deal is a building of money before it is a building of brick. The capital stack is the floor plan: senior debt on the bottom, then mezzanine or second-position debt, then preferred equity, then common equity on top. The rule that organizes all of it: the lower you sit, the sooner you are paid and the less you earn; the higher you sit, the later you are paid and the more you can make.

Senior debt, the bank, gets paid first and is protected by everyone above it; that safety is why it earns the least. Mezzanine steps in where the bank stops, charges more, and often holds the right to take the keys if payments stop. Preferred equity earns a stated return before the common sees a dime. Common equity, usually the operator and their investors, eats last and eats best, or not at all.

Reading the stack tells you what a deal really is. Thin common equity under heavy debt is a sprinter: brilliant if everything goes right, fragile if anything slips. Fat equity and modest debt is a marathoner: slower returns, deeper margin for error. Neither is wrong; what is wrong is not knowing which one you bought.

And when you raise money from others, say out loud where they sit, what gets paid before them, and what has to go wrong before they lose. Honest stack conversations up front are the cheapest litigation insurance ever invented.

Lower is safer and smaller. Higher is later and larger.

Who gets paid, in what order, when things go wrong

The capital stack is just the list of everyone who funded a deal, sorted by who gets paid first. Senior debt at the bottom takes the least risk and the lowest return. Equity at the top takes the most of both. Every layer between them is a negotiation about exactly that trade.

Why the order shapes the deal

Each layer’s cost reflects its position, and blending them sets your true cost of capital. Cheap senior debt with expensive preferred behind it can cost more than a slightly larger bank loan would have, and it is far harder to unwind. It also shapes behavior: a lender wants the loan paid, an investor wants the property sold at the top, and you may want to hold forever. Those conflicts are decided by where each party sits.

The same order governs a bad year. Senior debt gets paid or the building goes back. Then the seller note. Then preferred. Only then does the sponsor see anything, which is why I underwrite the stack at the worst NOI I can imagine, not the pro forma.

The version I use most

Senior debt at sixty-five to seventy, a seller carry where the seller wants price more than cash, and a small partnership on the equity. Three layers, three phone calls when something goes wrong, and everyone can explain who they are behind in one sentence. Elegance in a capital stack is how few people have to agree in a bad month.

How a seller note fits

The most useful layer for the deals I do is the seller carrying a note behind the bank. The seller wants full price; I want a smaller down payment; the bank will lend seventy percent. A ten or fifteen percent seller note bridges that, at a rate that is usually below what a mezzanine lender would charge, because the seller is motivated by closing rather than by yield. The senior lender has to approve subordinate debt, and the note has to be written so that a default on it does not trigger a default on the bank loan. That is a paragraph of legal work that has saved me from a great deal of trouble.

Reading someone else’s stack

When a sponsor asks you to invest, ask for the stack drawn out before you look at the returns. Where does your money sit, what is ahead of it, and what has to be paid before you see a dollar? A projected eighteen percent return in a common-equity slot behind a large mezzanine loan is a very different risk from the same number in a preferred slot behind conservative senior debt. Most investors compare the return and never compare the position, and the position is what decides whether the return exists in a bad year. If a sponsor cannot draw it on one page in two minutes, that is your answer.