Sheet 04
How real estate development is financed: the capital stack
Developers rarely build with their own money alone, so real estate development usually relies on several funding sources. The two main types of private financing are debt and equity. How do developers obtain financing, and in what order are these sources repaid? This guide explains the basic terms in a US context. It is not financial advice or an invitation to invest.
What is the capital stack in real estate?
The capital stack is the combination of debt and equity used to finance a real estate project, arranged by repayment priority. Senior debt comes first, mezzanine financing second, and equity last.
Debt usually comes from a lender, such as a bank or another institution. Equity is money that the developer or investors contribute to the project. The order matters because the lower a source sits in the stack, the later it is repaid. Each layer carries a different level of risk, which affects the expected return.
Think of the capital stack as a repayment queue. Each layer has its own place, and changing the proportions of debt and equity changes the risk for everyone involved.
A construction loan for a developer: what can it cover?
A construction loan is a specialized, short-term loan that covers the costs of building a residential or commercial property. It can cover land, contractor labor, materials and permits. Both developers and people building their own homes can apply.
Some construction loans can convert to a long-term mortgage once construction is complete. This is known as construction-to-permanent financing.
A construction loan is debt, so it must be repaid before equity in the capital stack. It is a key funding source for many projects, but not the only one.
What is mezzanine financing, and what does it cost?
Mezzanine financing sits between senior debt and equity in the capital stack. It can take the form of subordinated debt or preferred equity, combining features of both main types of financing.
If the borrower becomes insolvent, mezzanine financing is repaid only after all senior obligations have been met. That is why it costs more than secured debt, and its providers expect a higher return for taking on more risk. Interest can be paid in cash or as PIK (payable in kind), which means adding it to the debt balance. Under the PIK arrangement, the debt grows instead of interest being paid regularly in cash.
The cost of mezzanine financing reflects its position in the capital stack, not its name.
Why do leverage and the feasibility study matter?
Leverage makes financial difficulties in development different from those in ordinary investing. Debt magnifies both gains and losses, so an error in assumptions can cost more than it would in a project financed with equity alone.
Lenders and investors rely on the feasibility study to make funding decisions, so it must be objective. An overly optimistic assessment can distort those decisions.
Mixed-use projects can also be risky because a single property houses many types of tenants. These properties are harder to assess than those with a single type of user, making a sound feasibility study especially important.
How do real estate developers get financing in practice?
A developer can combine senior debt with mezzanine financing and cover the rest with equity from the developer or investors. Each source has a different cost and a different place in the repayment queue.
A sound feasibility study helps assess whether this financing arrangement is justified.
Summary
Real estate development is financed through a combination of senior debt, mezzanine financing and equity, arranged by repayment priority. The lower a source sits in this structure, the higher its risk and expected return. Choosing funding sources is one part of the development process, which we describe separately.