Real Estate Debt vs Equity: Where in the Capital Stack Should Family Capital Sit?

Family capital entering private real estate often defaults to common equity — the most familiar form of ownership. But the capital stack of any real estate deal includes three or four other tiers, each with a different position in the priority of payment and a different risk-return profile.

This piece walks through the standard tiers, the target returns each generates, and which type of capital is structurally well-suited to each tier.

The four tiers of the real estate capital stack

A typical institutional real estate deal has a capital stack that looks something like this:

Each tier moves down the priority of payment in exchange for higher target returns. Senior debt is repaid first, even in a partial loss; common equity is wiped out before any other tier takes a haircut.

Senior debt: the bond of real estate

Senior real estate debt — typically provided by commercial banks, life insurance companies, or debt funds — is the safest tier of the capital stack. Loan-to-value ratios are conservative (55 to 65 percent at acquisition), the loan is secured by a first-priority mortgage on the property, and in the event of default the lender has the right to foreclose.

Senior debt funds (sometimes called 'core debt' or 'first lien' funds) generate target net returns of 5 to 7 percent, with monthly or quarterly current distributions. The return profile resembles long-duration investment-grade corporate bonds: modest yield, low default risk, limited upside.

Best fit: capital that needs current income with downside protection — retired principals living off portfolio yield, foundations with annual distribution requirements, endowments matching liabilities.

Mezzanine debt: the middle tier

Mezzanine debt sits between senior debt and equity. It is typically secured not by the property directly but by a pledge of the equity interests in the property-owning entity. In a default, the mezzanine lender forecloses on the equity rather than on the property itself, replacing the common-equity sponsor.

Target returns are 10 to 13 percent, split between current interest (8 to 10 percent) and a back-end equity kicker or exit fee (2 to 3 percent). Mezzanine debt funds offer attractive risk-adjusted returns, particularly in markets where senior debt is constrained and mezz fills the gap.

The structural risk: in a serious downturn where property values fall 30 percent or more, mezzanine positions can be fully wiped out by the senior lender before any recovery is possible. The 2008 to 2010 vintage of mezzanine debt funds delivered widely varied outcomes.

Preferred equity: equity with a cap

Preferred equity sits above common equity in the capital stack but below all debt. It typically carries a fixed coupon (8 to 12 percent annual preferred return) plus a residual claim on profits in some structures, or simply a redemption right at a multiple of invested capital.

Preferred equity is most often used to bridge gaps in the capital stack when senior debt and common equity together cannot fund the full acquisition. It is structurally similar to mezzanine debt but without the secured lien.

Target net returns of 11 to 15 percent. Best fit: capital that wants equity-like returns with a defined exit (the preferred redemption) and seniority over the common sponsor's equity.

Common equity: the residual claimant

Common equity is what most LPs think of as real estate investing. It is the residual tier — last paid in a sale, first wiped out in a loss. In exchange, it captures all the upside above the other tiers' fixed claims.

Target returns vary widely by strategy: 8 to 11 percent for core-plus common equity, 12 to 18 percent for value-add, 17 percent and up for opportunistic. The leverage embedded in the capital stack (debt + mezz + pref above the common) amplifies both gains and losses.

How family capital should think about the stack

A common mistake is to view debt tiers as 'not real real estate investing' and concentrate the entire allocation in common equity. This is structurally inefficient for many family capital pools.

A pool of family capital that needs $400k per year of current distributions on $10M of real estate exposure cannot reliably generate that from common equity (which front-loads risk and back-loads returns). It can reliably generate it from a 70-percent allocation to senior or mezzanine debt and a 30-percent allocation to value-add common equity.

The blended return is lower (perhaps 9 to 11 percent net versus 14 percent net for all-common-equity), but the income profile is dramatically different — and for capital that has consumption requirements, the income profile usually matters more than the absolute return.

Frequently asked questions