Updated · Part of the CRE investment glossary
The four layers, from first paid to last
Diagrams usually draw the stack with senior debt at the bottom and common equity at the top. Cash flows up the stack: each layer is paid its current return before the next, and at a sale or refinance each layer is repaid in full before the next gets anything.
- Senior debt: the first mortgage loan, secured by the property. Lowest cost, first claim on cash flow and sale proceeds.
- Mezzanine debt: a loan to the owner of the property-owning entity, usually secured by a pledge of the ownership interests rather than the property. Its rights against the senior lender are set by an intercreditor agreement.
- Preferred equity: an equity class with a fixed preferred return and priority over common equity, often with a redemption date and the right to take control if it is not paid.
- Common equity: the investors and the sponsor. Paid last, with no fixed return, and all of the upside once the layers below are paid.
Last-dollar exposure
Lenders and investors ask how deep in the stack their money sits, measured against the value of the property:
Last-dollar exposure = (all capital senior to and including your layer) ÷ property value
- For senior debt this is simply the loan-to-value ratio (LTV).
- For preferred equity, add the senior loan, any mezzanine loan and the preferred equity itself.
- The higher the percentage, the smaller the fall in value it takes to reach your layer.
Worked example: a $10,000,000 deal
A sponsor buys a property for a total cost of $10,000,000. The stack below is illustrative, and the rates are assumptions for the example, not market quotes. The property earns $700,000 of net operating income (NOI) a year, and every layer is interest-only or current-pay.
Each layer is paid in order. Senior interest is $360,000, mezzanine interest $110,000 and the preferred equity return $120,000. That leaves $110,000 for common equity, a 5.5% cash yield on $2,000,000. Senior debt service coverage is about 1.94x; including the mezzanine loan it is about 1.49x. Preferred equity sits at 80% last-dollar exposure.
| Layer | Amount | Share | Last dollar | Annual payment |
|---|---|---|---|---|
| Senior loan (6%) | $6,000,000 | 60% | 60% | $360,000 |
| Mezzanine loan (11%) | $1,000,000 | 10% | 70% | $110,000 |
| Preferred equity (12%) | $1,000,000 | 10% | 80% | $120,000 |
| Common equity | $2,000,000 | 20% | 100% | $110,000 (residual) |
| Total | $10,000,000 | 100% | $700,000 (NOI) |
What happens at a sale
Leverage works in both directions, and it lands on common equity. Assume all current payments are up to date and compare two sale outcomes, net of costs.
If the property sells for $9,000,000, a 10% fall in value, the senior, mezzanine and preferred layers are repaid in full and common equity gets back $1,000,000 of its $2,000,000: a 50% loss. If it sells for $12,000,000, common equity receives $4,000,000, a 2.0x multiple before the sponsor’s promote. The fixed layers get the same amount either way.
| Layer | Sale at $9,000,000 | Sale at $12,000,000 |
|---|---|---|
| Senior loan | $6,000,000 | $6,000,000 |
| Mezzanine loan | $1,000,000 | $1,000,000 |
| Preferred equity | $1,000,000 | $1,000,000 |
| Common equity | $1,000,000 | $4,000,000 |
| Common equity multiple | 0.5x | 2.0x |
Mezzanine debt vs preferred equity
The two layers often sit at the same height and cost a similar amount, but they are different instruments. Mezzanine debt is a loan: it has a maturity date, its remedy is usually a foreclosure on the pledged ownership interests, and the interest is generally a deductible expense of the borrower.
Preferred equity is ownership. Its return is a distribution, not interest, and its remedies come from the operating agreement: a change of control, forced sale or conversion if the return or redemption is missed. Senior loan documents often limit or prohibit additional debt, which is one reason sponsors use preferred equity instead.
What to watch for
Questions that change the risk of a stack more than the headline LTV:
- Control rights: what preferred equity or a mezzanine lender can do to the sponsor and common investors after a missed payment.
- Combined debt service coverage, not just coverage on the senior loan.
- Floating rates, maturity dates and redemption dates that come before the business plan is finished.
- Accruing returns: an unpaid preferred return can compound ahead of common equity.
- Confusing preferred equity (a senior class of capital) with a preferred return (a tier in the common equity waterfall).
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.