# Structuring debt and the power of leverage
You buy an office building for $50 million. You put in $15 million of your own cash and borrow the other $35 million. The building throws off $3.5 million in annual net income. Your return on that income, measured against your $15 million, is far higher than 7 percent. That gap is leverage, and learning to structure it is the single most important financial skill in real estate.
Let's build the capital stack for that office acquisition piece by piece, and watch how each layer changes both your returns and your lender's risk.
The "capital stack" is the ordered list of who gets paid, and in what priority, from a property's cash flow and eventual sale.
From safest (lowest return) to riskiest (highest return):
The rule that governs everything: lower in the stack means higher risk, so those investors demand higher returns.
Loan-to-value (LTV) is the loan amount divided by property value. Here, $30M / $50M = 60 percent LTVLTVLifetime Value: the total revenue (or profit) a customer generates throughout their entire relationship with your business.View full definition →. Most senior lenders on stabilized office cap out around 55 to 65 percent today, lower than the pre-2022 norms because office values have been under pressure.
Two covenants (contractual promises to the lender) shape the deal:
Debt service coverage ratio (DSCR) measures whether income comfortably covers loan payments. It is net operating income (NOI) divided by annual debt service (principal plus interest).
If NOI is $3.5M and annual debt service is $2.3M, DSCR = 1.52x. Lenders typically require a minimum, often 1.20x to 1.35x. Fall below it and you may trigger a default or a cash sweep (the lender captures excess cash instead of letting it flow to you).
Amortization is how the principal gets repaid over time. A loan can be:
Many commercial loans use a balloon structure: partial amortization over a 10-year term, with a large final payment (the "balloon") requiring a refinance or sale.
Say you want more leverage. A senior lender won't go above $30M, but a mezz lender will add $8M on top.
Now total debt is $38M against $50M value, or 76 percent LTVLTVLifetime Value: the total revenue (or profit) a customer generates throughout their entire relationship with your business.View full definition →. Your cash requirement drops from $20M to $12M.
Mezzanine debt is technically not secured by the building's mortgage. Instead it is typically secured by a pledge of the ownership interests in the entity that owns the property. If you default on the mezz, the mezz lender can take over your equity rather than foreclose on the real estate directly. This is governed in the US by frameworks under the Uniform Commercial Code.
Because mezz sits behind the senior loan, it is riskier and priced higher. Senior office debt today might carry an interest rate in the high single digits; mezz commonly runs several points above that.
The key metric expands here. Lenders look at the combined DSCR including mezz payments. Adding an $8M mezz layer raises your total debt service, which pushes combined DSCR down, closer to the danger zone. More leverage, thinner cushion.
You still need to close the remaining gap. Instead of more debt, bring in a preferred equity investor for $6M.
Preferred equity gets a fixed return (a "preferred return," say 10 to 12 percent) and gets paid before you, the common equity holder. But it is not debt. It does not usually trigger foreclosure or count against LTVLTVLifetime Value: the total revenue (or profit) a customer generates throughout their entire relationship with your business.View full definition → covenants the same way, which senior lenders often prefer.
Now the stack looks like this:
| Layer | Amount | Position | Typical cost |
|---|---|---|---|
| Senior mortgage | $30M | 1st | high single digits |
| Mezzanine debt | $8M | 2nd | several points higher |
| Preferred equity | $6M | 3rd | ~10 to 12% |
| Common equity | $6M | Last | all remaining upside |
You have reduced your own cash from $20M to $6M on the same $50M asset.
Here is the payoff and the peril. Cash-on-cash return is annual cash flow to common equity divided by common equity invested.
Scenario A, low leverage: $20M equity, only the senior loan. After $2.3M debt service, $1.2M flows to you. Cash-on-cash = $1.2M / $20M = 6 percent.
Scenario B, high leverage: $6M common equity, with mezz and preferred layered in. After paying senior, mezz, and preferred returns, suppose $0.6M reaches common equity. Cash-on-cash = $0.6M / $6M = 10 percent.
More leverage lifted your return from 6 percent to 10 percent on the same building. That is the "power" in the lesson title.
But run it in reverse. Suppose NOI falls 15 percent because a tenant vacates. In Scenario A, you still cover debt service comfortably. In Scenario B, your combined debt service and preferred return may exceed NOI. Common equity gets zero, and you may breach a DSCR covenant, triggering a cash sweep or default.
Leverage magnifies returns in both directions. It is a return amplifier on the way up and a loss accelerator on the way down.
🎬 [VIDEO: "How the Real Estate Capital Stack Works" — youtube.com — a clear walkthrough of debt and equity layers in a commercial deal]
Each layer prices risk based on its position and cushion.
Covenants are the lender's early warning system. A DSCR test catches trouble before a missed payment. A cash sweep redirects money to pay down debt when coverage weakens, protecting the lender at the expense of the sponsor's distributions.
For a solid primer on these mechanics, the Corporate Finance Institute's real estate resources are a free starting point.
Knowledge check
1. What fundamental principle explains why the different layers of the capital stack command different rates of return?
2. Leverage boosts equity returns primarily because:
3. A lender is evaluating a stabilized office loan and finds the DSCR is only 1.05x against a required minimum of 1.25x. What does this signal about the deal?
4. Select ALL correct answers about loan-to-value (LTV) as a risk measure for senior lenders.
Select all the correct answers.
5. Select ALL correct answers that correctly describe positions within the capital stack.
Select all the correct answers.
Smart structuring is about matching the debt to the business plan.
Stabilized, fully leased office: predictable income supports amortizing senior debt with a comfortable DSCR. You trade some current cash flow for equity buildup.
Value-add office (renovate and re-lease): income is low today and expected to grow. Here sponsors often use interest-only periods to keep payments low while NOI ramps, then refinance once the property stabilizes.
Interest rate risk: floating-rate loans move with benchmark rates. After the sharp rate increases of 2022 to 2023, many sponsors who used floating-rate debt saw payments jump and DSCR compress. A rate cap (a hedge that limits how high your rate can go) became a common lender requirement. Never assume rates stay put.
Refinance risk: balloon maturities are dangerous when values fall. A loan sized at 60 percent LTVLTVLifetime Value: the total revenue (or profit) a customer generates throughout their entire relationship with your business.View full definition → on a $50M building becomes 75 percent LTVLTVLifetime Value: the total revenue (or profit) a customer generates throughout their entire relationship with your business.View full definition → if the building is later worth $40M. Refinancing the same balance may be impossible without injecting fresh equity. This "maturity wall" is a real concern for office loans coming due through 2026 and beyond.
Structuring debt is a series of trade-offs, not a search for maximum leverage:
The best sponsors size leverage to survive a downturn, not just to shine in a spreadsheet.