A typical commercial real-estate deal is bought by a single entity but funded by four different kinds of capital, each at a different price and with different rights. The four-tier capital stack — senior debt, mezzanine, preferred equity, common equity — is the language the industry uses to describe who paid what and who gets what back, in what order. Once you can read a capital stack, you can read 80% of what a deal memo is telling you.
The four tiers, top to bottom
┌──────────────────────────────────────────┐│ Common Equity (LP + GP) │ Last paid · Highest return target│ ─────────────────────────────────────── │ IRR target: 15-25% net├──────────────────────────────────────────┤│ Preferred Equity ││ ─────────────────────────────────────── │ Coupon: 8-12% with PIK option├──────────────────────────────────────────┤│ Mezzanine Debt ││ ─────────────────────────────────────── │ Coupon: 10-14% cash├──────────────────────────────────────────┤│ Senior Debt (the mortgage) │ First paid · Lowest cost│ │ Rate: 8-14% depending on market└──────────────────────────────────────────┘
- Senior debt is the primary mortgage. Secured by a first lien on the property, paid first from operating cash flow and from sale proceeds. Lowest cost (in Kenya 12-15%; in mature low-rate markets 4-7%). Typically 50-70% of the capital stack. The lender's recovery in a default is the property itself.
- Mezzanine debt sits between senior debt and equity. Often secured by a pledge of the equity interests in the property-owning entity (not the property itself), so it's structurally junior to the mortgage. Cost 10-14% cash plus sometimes an exit fee or equity warrant. Used to fill the gap between what senior debt will lend and what equity wants to put in.
- Preferred equity behaves like a junior layer of debt — it has a coupon (the 'pref'), usually 8-12%, sometimes paid-in-kind (PIK, capitalised onto the balance), and seniority over common equity but no claim on the property in foreclosure. Often used by sponsors who want capital that doesn't dilute their common-equity upside above a hurdle rate.
- Common equity is the residual claimant. Gets paid only after senior debt, mezzanine, and preferred have been served. Maximum upside, maximum downside. Common equity is itself usually split between Limited Partners (LPs, who provide most of the cash) and a General Partner (GP, who runs the deal and provides a small slice of cash plus all the operational work). The GP's compensation is mostly the promote, defined below.
The waterfall — how cash actually splits
When the property generates cash — either operating cash flow during the hold or sale proceeds at exit — that cash flows down the stack in priority order. The senior lender takes their interest and principal first; if anything is left, the mezzanine lender takes their coupon; if anything is left after that, the preferred equity takes its pref; if anything is left after that, common equity gets it. This sequential distribution rule is called a waterfall.
Inside the common equity, the LP/GP split is also waterfall-based. A standard LP/GP waterfall for a real estate deal has these tiers:
Tier 1 — Return of capitalAll cash flows pro rata until LP and GP have received back the capital theycontributed at close. No profit yet — just return of money put in.Tier 2 — Preferred return ('the pref')Cash flows pro rata until both LP and GP have received an 8% (typical)annualised return on the capital they contributed. Still no profit-sharing.Tier 3 — Catch-up (sometimes)100% of cash flow to GP until the GP's profit equals (promote% / (1 − promote%))times the LP's profit. Not all deals have a catch-up.Tier 4 — Promote ('the carry' / 'the split')All cash flows above the pref are split, typically 80/20 LP/GP or 70/30 LP/GP.THIS is where the GP makes their real money. The pref is the LP's promiseto themselves; the promote is the GP's payday.
Why the structure exists
The LP/GP / waterfall / promote structure solves an alignment problem. The LPs (pension funds, family offices, high-net-worth individuals, endowments) have capital but don't have the time or expertise to run a property. The GP (the sponsor) has expertise but doesn't have enough capital to do the deal alone. The waterfall says: LPs get their money back first, then their 'safe' return, and only after that does the GP share in the profits. This makes the GP work hard to clear the pref before their compensation kicks in — and gives them outsized upside if the deal really works.
Worked example — a small LP/GP deal
Kenyan office building, KES 200m purchase price, 60% LTV.Senior mortgage: KES 120m at 13%Equity check: KES 80mLP contributes: 72m (90% of equity)GP contributes: 8m (10% of equity)Sponsor promote: 20% above an 8% pref (LP and GP both get pref pro rata)Five-year hold. Sale at end of year 5 for KES 285m. Loan paid down to 100mover the hold. Cumulative operating cash to equity over the hold: KES 38m.Total equity proceeds (operating + sale) = 38m + (285m − 100m) = 223mTotal equity profit = 223m − 80m = 143mWaterfall:Tier 1 — return of capital: LP 72m, GP 8m → 80m returned, 143m remainsTier 2 — 8% pref on capital × 5 yrs (simplified): pro rata 0.08 × 5 × 80m = 32mLP gets 0.9 × 32 = 28.8m; GP gets 0.1 × 32 = 3.2mRemaining after pref: 143m − 32m = 111mTier 4 — promote: 80% LP / 20% GP on the 111m above the prefLP: 0.8 × 111 = 88.8mGP: 0.2 × 111 = 22.2mFinal numbers:LP receives: 72m + 28.8m + 88.8m = 189.6m on 72m contributed → IRR ~21%GP receives: 8m + 3.2m + 22.2m = 33.4m on 8m contributed → IRR ~33%Note: GP put in 10% of the equity and is taking 23% of the total equityproceeds. That's the promote at work. On a bad deal where the proceeds don'tclear the pref, the GP gets just their 10% pro rata share. The asymmetry ISthe incentive.
The leverage paradox, quantified
Module 3 introduced unlevered vs levered IRR. Now we can be precise about how leverage amplifies returns and losses. Take the same building and finance it at three different LTV levels. Hold the underlying NOI and sale price constant.
Property: 5-year hold, KES 200m purchase, KES 38m total operating cash,KES 285m sale, KES 13% mortgage rate, interest-only.0% LTV 60% LTV 75% LTV──────── ───────── ─────────Equity check 200m 80m 50mDebt service — none 15.6m/yr 19.5m/yrLevered cash 38m 38m − 78m 38m − 97.5mover 5 yrs + 85m sale = −40m = −59.5m+ 165m sale + 135m sale= 125m = 75.5mLevered IRR ~ 13% ~ 21% ~ 30% (better)Now assume NOI drops 25% — sale price drops to 215m instead of 285m.Levered IRR ~ 5% ~ 4% ~ −8% (worse)The gap between the 75% LTV and 0% LTV cases is 12 percentage points widerin both directions. Symmetric on paper. Not symmetric in lived experience —in the −8% case the equity sponsor is fighting their lender, while theunleveraged investor is just disappointed.
Leverage doesn't create return — it amplifies whatever the underlying produces
The 30% IRR in the high-leverage case isn't 'because of the financial engineering'. It's because the unlevered building produced a positive return AND debt was cheaper than the unlevered return. Apply the same leverage to a flat property in a flat market and the levered return is negative — you're paying 13% interest to own something that earned 8%. Module 3's point about high-rate environments is the same point: leverage is a tool that only works when the underlying yield beats the cost of debt.
Exercise
A Nairobi sponsor proposes a KES 300m office deal. Capital stack: KES 180m senior debt at 13%, KES 30m preferred equity at 10% pref, KES 90m common equity (LP 81m / GP 9m, 80/20 promote above 8% pref). Five-year hold. The property generates KES 30m of cash for distribution per year and sells for KES 360m at end of year 5. (1) Compute total senior debt service over 5 years (assume interest-only). (2) Compute total preferred equity coupon paid over 5 years. (3) Compute the levered cash flow available to common equity over the 5 years (operating + sale net of loan repayment + preferred return of capital). (4) Walk through the common equity waterfall: how much does LP receive total? How much does GP receive total?