Commercial real estate financing is structured in layers (the capital stack), each with a defined risk and return profile. Senior debt sits at the top of the priority waterfall, first to be repaid with the lowest risk and lowest rate, and typically represents 60-75% of total capitalization on stabilized assets.
Below senior debt sit mezzanine debt and preferred equity, which absorb losses before the common equity and receive higher returns in exchange. Common equity sits at the bottom: last in priority, highest risk, highest return target.
Understanding where each dollar in the capital stack sits relative to the others determines every dollar's risk-adjusted yield, call rights, and loss exposure.
The senior debt market spans several product types matched to different asset life-cycle stages. Construction loans are short-term (typically 24-36 months), floating-rate facilities that fund in draws against verified completion milestones, sized at 60-70% of total project cost (loan-to-cost).
Bridge loans are short-term stabilization facilities for value-add acquisitions (properties not yet at stabilized occupancy), sized at 65-75% LTV on an as-stabilized basis. Permanent loans are long-term (5-10-year term, 20-30-year amortization), fixed or floating rate, typically 65-75% LTV on stabilized assets.
Agency loans (Fannie Mae and Freddie Mac in the United States, CMHC MLI Select in Canada) offer the best available terms for multifamily. CMBS (commercial mortgage-backed securities) offers non-recourse financing at scale but comes with prepayment lockouts such as yield maintenance or defeasance, and limited flexibility for asset management changes.
Lenders evaluate debt risk through three primary metrics. Debt service coverage ratio (DSCR), net operating income divided by annual debt service, must typically clear 1.20x-1.25x at underwriting.
Loan-to-value (LTV), loan amount divided by appraised value, is the primary constraint on smaller loans; most senior lenders cap at 65-75% LTV for income-producing assets. Debt yield (NOI divided by the loan amount) is the metric that has gained primacy in institutional lending because it is independent of interest rates and cap rates; lenders use it to gauge the actual return they would receive if they had to take back the property.
Debt yield floors of 7-9% are common in institutional CMBS and life company lending.
The equity side of the capital stack typically follows a limited partnership structure in institutional transactions. The general partner (GP) contributes 10-20% of the equity and controls asset management decisions; limited partners (LPs) contribute 80-90% of equity capital and take a passive role.
Distributions flow through a waterfall: LPs first receive a preferred return (commonly 7-9% IRR hurdle) on their invested capital; once the preferred return is satisfied, the GP receives a disproportionate share of further profits (the promote or carried interest, typically 20-30% of proceeds above the hurdle). Mezzanine debt and preferred equity fill the gap between senior debt proceeds and available common equity, accepting a defined yield (typically 10-14%) in exchange for structural priority over the LP equity and, in default scenarios, the right to foreclose on the GP's interest.
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