When developers raise capital for a commercial real estate (CRE) project, they rely on multiple funding sources.  Understanding where your investment fits within the “capital stack” will help you assess the level of risk you are assuming. Imagine the capital stack as layers necessary to fund and operate a CRE venture. The higher your position in the stack, the lower your comparative risk.

Institutions like banks, insurance companies, pension funds, investment managers, sovereign wealth funds, as well as private investment groups and funds often target the upper tiers of the capital stack in real estate projects such as industrial parks or shopping areas. Family offices and high-net-worth individuals also engage in these types of investments, but frequently they invest in the lower layers of the stack.

Senior Debt: This forms the bedrock of a CRE project’s financing.  A sponsor’s primary objective is to secure most funding from institutional lenders, as this financing comes at a lower cost.  However, sponsors typically manage to secure only 60-70% of the required capital through senior debt. Terms like senior permanent loans, bridge loans, or construction loans describe this segment.  In existing projects, senior loans tend to be permanent, while new projects often use financing for property acquisition and improvements—such as value-add situations, like leasing up an office building post-acquisition.

Mezzanine Financing: As developers move down the capital stack, they seek mezzanine funding, also known as “subordinated” or “junior” financing.  Although this costs the sponsor more, it contributes another 10% to the project’s capitalization and helps developers minimize the equity needed to support their project.

Equity Financing: To complete the financing round, sponsors ultimately offer equity to investors, despite diluting their ownership.  Depending on the project’s needs, sponsors may structure equity investments in different forms, including preferred, participating preferred, convertible preferred, or common equity.

Experienced developers understand how to blend debt and equity strategically to finance their CRE ventures effectively.  Knowing your place in the funding hierarchy, along with researching the issuer’s track record, will help you become a more informed CRE investor.

For a deeper exploration of the commercial real estate sector, please refer to “Investing in Commercial Real Estate” and its companion paper, “Investing in Real Estate.”