Capital Stack Real Estate: Who Is Paid

A capital stack real estate diagram is the payment order sponsors sketch before they raise money. It lists every claim on one property, from the first mortgage down to the last dollar of common equity. Cash flow and sale proceeds move down that list. Losses move up from the bottom.

The four slices investors argue about are senior debt, mezzanine debt, preferred equity, and common equity. A mezzanine loan has its own product page at mezzanine financing. Preferred equity has its own page at preferred equity real estate. This page is the map those slices sit on. It is not a term sheet for any one of them.

IRS Publication 541 describes the equity side when the venture is a partnership. A partnership generally does not pay income tax. It passes profits and losses through to its partners, and the partners report those items. The mortgage is a partnership liability. Preferred equity and common equity are ownership. The operating agreement’s waterfall is the contract among those owners. The tax allocation is a separate schedule. Publication 541 also defines guaranteed payments as amounts determined without regard to the partnership’s income. A preferred return that is paid only when cash exists is not automatically that kind of payment. The label in the pitch book does not decide the tax character.

Illustrations on this page are arithmetic. They are not a rate quote, a target return, or an offer of credit. An inquiry is not an approval.

How a capital stack real estate diagram pays

Senior debt is the first mortgage. It is paid from operating cash before anyone else, and it is paid first from a sale or refinance. The lender’s protection is the lien, the cash-flow cushion, and, on many loans, a guaranty or a set of carve-outs. If the property is worth less than the senior balance, the senior lender is the party with the foreclosure remedy against the real estate.

Mezzanine debt is still a loan. It is paid after the senior loan is current. The collateral is often a pledge of the equity in the property owner, not a second mortgage on the dirt. The rate is higher because the mezzanine lender is behind the senior lien and in front of the owners. If cash runs out, mezzanine is impaired before the senior loan is.

Preferred equity is ownership with a contractual preference. It is paid after debt service and before common equity, to the extent the agreement says so. The holder owns a slice of the entity. The holder does not, merely by being preferred, hold a mortgage on the building. What that slice can force is covered on the preferred-equity page. On this map, the only point is position: behind the loans, ahead of common.

Common equity is the residual. It is paid last. It keeps what is left after debt and the preferred claim. It also absorbs the first loss. Sponsors and their partners usually sit here, and they usually control day-to-day decisions until a default shifts those rights.

Slice	What it is	Paid	First loss
Senior debt	First mortgage	First	Last
Mezzanine debt	Junior loan, often secured by equity	After senior	After preferred equity
Preferred equity	Ownership with a preference	After debt	After common
Common equity	Residual ownership	Last	First

Documents move these lines. A senior lender can forbid mezzanine or preferred equity, or allow them only under an intercreditor agreement. A preferred holder can negotiate a forced sale. Read the recorded mortgage, the pledge, and the operating agreement as one stack. The diagram in the offering is the summary. The contracts are the stack.

A sale, then a shortfall

Suppose a property sells and the net proceeds, after sale costs, are $10,000,000. The senior loan is owed $6,000,000. Mezzanine is owed $1,500,000. Preferred equity contributed $1,000,000 and is owed $200,000 of unpaid preference. Common equity contributed $1,500,000. Nobody is promised these results. The waterfall below follows the order in the table.

Senior debt receives $6,000,000. Remaining proceeds: $4,000,000.
Mezzanine receives $1,500,000. Remaining proceeds: $2,500,000.
Preferred equity receives $1,200,000. Remaining proceeds: $1,300,000.
Common equity receives the $1,300,000 residual.

Common contributed $1,500,000 and receives $1,300,000. That $200,000 gap is the first loss. Preferred and both lenders are paid in full in this picture. Change the net proceeds to $7,000,000 and the picture changes. Senior still takes $6,000,000. Only $1,000,000 remains. Mezzanine is short $500,000. Preferred and common receive nothing. The loss climbed the stack.

Operating cash flow can use a different order from a sale. A current preferred return may be paid each quarter from cash left after debt service, while unpaid preference accrues and waits for a sale. Common may receive nothing for years and still own the upside if the sale price clears the stack. Ask which waterfall applies to monthly cash and which applies to a capital event. They are often two sections of the same agreement.

Who eats the loss, and who does not

Losses start at common equity because common is the cushion the other slices priced. If common is thin, preferred equity is the next cushion, then mezzanine, then the senior loan. A stack that looks safe at the senior loan can still wipe out the people who wrote the check for the down payment. That is the point of reading the diagram before you choose a slice.

The senior lender did not “eat” the owner’s loss by foreclosing. Foreclosure is how the lender tries to stop its own loss. After a foreclosure, equity is often gone. Preferred equity does not become a mortgage because the property struggled. Its remedies are the ones in the operating agreement and any pledge the senior lender allowed.

Tax follows the partnership rules, not the pitch. Publication 541 is where partners start on allocations, distributions, and guaranteed payments. A distribution that follows the waterfall can differ from the taxable income allocated on Schedule K-1. Cash in your account and income on the K-1 are two reports. This page does not reconcile them. It only separates the contract order from the tax return.

What the stack does not decide

The stack does not set the interest rate on the senior loan. The senior lender prices the lien, the coverage, the property, and the sponsor. Junior slices can make that lender more cautious, because more claims sit behind it, and the intercreditor agreement is extra work. They do not entitle the sponsor to a particular rate.

The stack does not turn a preferred return into a result the property must produce. If the rent does not cover debt service, the preference accrues or fails according to the agreement, and the senior loan is still due. A diagram with four neat boxes is a teaching tool. The rent roll is the cash.

Use the stack when you are choosing where to invest, or when you are asked to sign a subordinate document on a property you already own. Name the slice. Name what is owed ahead of it. Name what has to go wrong before your dollar is touched. Then read the agreement that actually creates that slice.

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Frequently Asked Questions

Who is paid first in a capital stack?

The senior lender is paid first from cash flow and from a sale or refinance. Mezzanine debt is paid next when the documents put it there. Preferred equity is paid after the debt and before common equity. Common equity receives what remains. An intercreditor agreement can change the remedies even when this order is the economic plan.

Is preferred equity just another loan?

Preferred equity is ownership with a contractual preference. Mezzanine is a loan, often secured by a pledge of equity. The preferred holder usually cannot foreclose the building the way a first mortgage can. Both sit behind the senior loan. The difference is what the holder owns and which contract describes the default.

Who loses money first if the property is sold short?

Common equity absorbs the first loss. Preferred equity is next, then mezzanine, then the senior loan. In the shortfall example on this page, a lower sale price wiped out common and preferred and left mezzanine unpaid, while the senior loan was still covered. Your agreement can define a different residual split after the debts are paid.

Does the stack change my tax?

The payment order is the deal. The tax return follows partnership rules when the owners are partners. IRS Publication 541 explains that a partnership passes profits and losses through to the partners, and it defines guaranteed payments as amounts set without regard to partnership income. A preferred return paid only from available cash is not automatically a guaranteed payment. Ask a tax adviser which one your agreement is.

Can I add mezzanine or preferred equity later?

Only if the senior loan allows it. Many mortgages restrict new debt and new preferred equity unless the lender consents. Adding a slice without that consent can be a default on the mortgage even when the new money feels helpful. Read the transfer and subordinate-financing sections before you raise the junior capital.