Capital Stack Compression: Navigating Risk and Return in 2025’s Real Estate Deals
Introduction
The U.S. commercial real estate market in mid-2025 stands in a very different place than the free-money era of the 2010s. Rising interest rates and cautious banks have compressed the capital stack of many deals – meaning the traditional layers of debt and equity financing have been squeezed and rearranged. Equity cushions have shrunk, debt spreads have tightened, and hybrid financing structures are proliferating. For family offices, limited partners (LPs), foreign investors and experienced sponsors, this compressed capital stack era presents a new landscape of risk and return. Navigating it requires both an institutional understanding of market dynamics and a keen, opinionated strategy on how to structure deals in today’s environment.
In this article, we examine how capital stack compression is unfolding in 2025. We explore the prevalence of shrinking equity positions, the surge of preferred equity, mezzanine debt, and rescue capital, and innovations in senior–subordinate structures. We analyze what these shifts mean for projected IRRs, refinancing risk, and how investors allocate risk. We also integrate a global perspective – looking at how macroeconomic and geopolitical forces like global capital rotation, interest rate policy divergence, currency fluctuations, and cross-border capital flows are influencing U.S. commercial real estate. Finally, we conclude with strategic recommendations for CRE deal sponsors and investors seeking to thrive in this era of compressed capital stacks.
Shrinking Equity Cushions in a Compressed Capital Stack
In 2025, many real estate deals have far less true equity at risk than in previous years. Sponsors and developers are reducing their reliance on common equity and instead stacking on more debt-like capital to finance projects (citrincooperman.com). This means the “first-loss” equity piece – the cushion that absorbs any decline in asset value – has gotten thinner. A variety of factors have driven this trend. Property valuations have adjusted downward since their peak in 2022, eroding the equity in existing deals and making new equity investments more cautious. Meanwhile, interest rates spiked during 2022–2023, raising borrowing costs and pressuring leveraged returns (bradvisors.com). To keep projects viable and returns attractive, sponsors have been filling funding gaps with mezzanine loans and preferred equity rather than pouring in more common equity capital (bradvisors.com). The result is a compressed capital stack: senior lenders still provide a base loan, but above that sits layers of mezzanine debt or preferred equity, leaving only a thin sliver of true equity at the bottom.
Figure: Heavy debt burdens act as an anchor on real estate values. A metaphorical illustration of a hot air balloon (representing property values) tied to a falling arrow (representing rising interest costs) mirrors how higher financing costs and increased leverage can weigh down CRE deals. In today’s market, elevated interest expenses have indeed become an anchor on cash flows and valuations, forcing creative financing solutions to keep deals afloat. Traditional banks have curtailed loan-to-value ratios (often now maxing out at ~50–55% loan-to-cost, down from 60–65% before 2023) (prea.org). This bank retreat has left borrowers scrambling to complete the capital stack with more expensive subordinate capital (prea.org). Sponsors that once might have contributed 30–40% equity are now often contributing far less common equity, supplementing with debt fund financing. As one industry report notes, real estate firms are “moving away from equity toward debt – specifically, to preferred equity and mezzanine debt or ‘bridge loans’” (citrincooperman.com). These additional layers provide the needed funding but come with higher return requirements and priority claims, fundamentally reshaping the risk profile of deals.
Crucially, shrinking equity cushions mean higher risk for all parts of the stack. With a smaller equity buffer to absorb losses, senior lenders and mezzanine/pref investors face a greater chance of impairment if asset values decline even modestly. Lenders know this, which is why they are intensely focused on sponsor quality and commitment in 2025. Deals today are scrutinized for “how much skin” the sponsor is putting in and whether they have the track record and liquidity to backstop the project (credaily.com, credaily.com). In short, while sponsors might prefer to minimize their true equity at risk, they must convince capital providers that the deal still has enough cushion and a credible plan. Sponsor strength and alignment have become paramount – weak sponsors who can’t contribute meaningful equity or demonstrate reliability are finding their deals dead on arrival (credaily.com). This is one reason we are seeing an emphasis on strong joint ventures and co-investments, where experienced partners or institutional capital step in to bolster the equity slice and satisfy lender concerns. Even so, capital stack compression remains prevalent, as most market players seek to optimize their financing mix in an era of expensive capital.
Preferred Equity and Mezzanine Debt: Filling the Gap
To bridge the shortfall between what cautious senior lenders will fund and the equity that sponsors are willing or able to contribute, preferred equity and mezzanine debt have become financing mainstays in 2025. These hybrid structures sit in the middle of the capital stack – junior to the senior mortgage but senior to the common equity. They effectively fill the gap and allow deals to achieve higher leverage (often 70%–80% of project cost) without relying on common equity for that entire stretch (prea.org).
Preferred equity behaves economically like subordinated debt: the preferred investor contributes capital in exchange for a fixed return (often paid current or accrued) and priority in the cash flow waterfall, but typically does not take a share of residual profits beyond their agreed return. In essence, the preferred equity holder gets “debt-like” treatment (a pref return) without being secured by the property – though they may hold a membership interest in the ownership entity and certain rights (e.g. approval or takeover rights if the deal underperforms) (citrincooperman.com). Mezzanine debt, by contrast, is an actual loan secured not by the property directly but by a pledge of equity (ownership interests) in the property-owning entity. Mezzanine loans charge interest (often in the mid to high single-digit percentage points above base rates, translating to mid-teens IRRs in today’s environment) (yieldpro.com). They usually include default provisions allowing the mezz lender to foreclose on the equity interest (essentially taking over the project) if the borrower fails to pay. In practice, preferred equity and mezzanine debt are quite similar in their position and risk – both are junior capital that expects a higher return for taking second-tier risk behind the senior mortgage.
In 2025’s high-rate environment, the returns demanded by these gap fillers are steep. Preferred equity investors often seek returns on the order of 12%–16%, sometimes higher for riskier deals (yieldpro.com, yieldpro.com). Mezzanine debt coupons likewise often land in the low- to mid-teens. These rates reflect the increased risk (thin equity below them) and the scarcity of capital willing to take that risk. Yet from the perspective of many investors, these yields are quite attractive relative to recent history – they are “equity-like returns” for a more secure position in the stack (prea.org). Indeed, industry surveys show a growing appetite among institutional investors and family offices to deploy capital into real estate debt strategies, precisely because they can earn double-digit yields while sitting senior to someone else’s equity (prea.org). The result has been an influx of private debt funds, alternative lenders, and even PE firms offering preferred equity and mezzanine financing. As one report notes, “debt products are the investment vehicle of choice as common equity struggles to adjust to rapidly changing valuations,” allowing investors to reshuffle risk and avoid being fully exposed on the equity (prea.org)(citrincooperman.com). In other words, rather than invest as an LP in the common equity of a deal (with high risk and uncertain upside), an investor might prefer to provide a mezz loan or pref equity tranche – effectively acting as a lender with a set return, leaving the sponsor’s thin equity to absorb most volatility.
For sponsors, these hybrid capital tools offer flexibility to get deals done that otherwise wouldn’t pencil out. By layering a pref or mezz piece on top of senior debt, a sponsor can achieve higher overall leverage (perhaps 75%–85% of project value) while limiting their own cash equity investment to maybe 15%–25%. This can juice the sponsor’s potential IRR on that equity (since less cash in, and that equity only earns residual profits after cheaper capital is paid). It can also solve short-term funding gaps – for example, financing a construction cost overrun or a value-add renovation – without diluting the sponsor’s ownership via bringing in a new common equity partner. However, this comes at the cost of a heavier debt service burden and strict payment priorities. The preferred/mezz investors will usually require regular interest or accrued returns and may impose covenants. Sponsors must carefully negotiate terms (such as the ability to prepay, cure rights, and what control rights the pref/mezz holder has). The 2025 market has spurred innovation in deal terms – we see structures like PIK (paid-in-kind) interest that accrues to reduce immediate cash drain, convertible preferred equity that can flip into equity if not redeemed by a certain date, warrants or profit participation kicker in some mezz deals, and other senior-subordinate permutations (citrincooperman.com). These innovations aim to bridge the pricing gap between what borrowers can afford and what yield investors require, effectively sharing risk and upside in creative ways.
It’s worth noting that alternative lenders are actively capitalizing on these opportunities. Debt funds, mortgage REITs, private credit arms, and even insurance companies have stepped in to provide high-yield subordinate financing that banks won’t (bradvisors.com) (prea.org). Life insurance companies, for instance, have expanded their “stretch senior” loans – lending beyond typical conservative LTVs but at higher spreads – to high-quality sponsors, effectively competing in the mezz/pref space with more borrower-friendly terms (prea.org). Overall, the surge in preferred equity and mezzanine usage is a direct response to the financing gap left by retreating banks and the need to offset higher senior loan rates. By filling this gap, these tools keep deals moving forward – but they also mean most deals now carry a more complex capital structure. Investors and sponsors must be adept at negotiating intercreditor agreements (between senior lender and mezz lender/pref equity) and modeling layered payouts. The complexity is a new normal, but those who master it can still transact in a tough market.
Rescue Capital and Senior-Subordinate Innovations in Distress
One particular area where capital stack creativity is on full display is in distressed or near-distressed situations – deals facing maturity defaults, cash flow shortfalls, or other stress where additional capital is needed urgently. In such cases, “rescue capital” has emerged as a buzzword in 2024–2025. Rescue capital refers to infusions of money (often structured as preferred equity or junior debt) that bail out an overleveraged asset, allowing it to refinance or stabilize rather than go into foreclosure. With an estimated $2.6 trillion of CRE loans coming due over 2023–2028 (prea.org), and many legacy loans underwritten at yesterday’s low rates, the need for rescue refinancing has been tremendous. Owners of properties whose values have fallen 20%+ from the peak find that they “can’t afford to refinance” at today’s higher rates without additional equity (yieldpro.com). Lenders refinancing these loans are often demanding substantial pay-downs – effectively, a new equity injection – to meet lower loan-to-value requirements and ensure a cushion. This is where rescue capital providers step in.
So far, investors from family offices to private equity debt funds have raised significant pools of rescue capital to deploy into troubled deals (yieldpro.com). These investors are enticed by the prospect of high yields and favorable terms: rescue financings can command IRRs in the mid-teens to low-20s depending on risk (yieldpro.com). The structure is typically a mezzanine loan or preferred equity position that comes in new, sitting on top of (or alongside) the existing senior loan. In exchange for, say, injecting a few million dollars to cure a loan default or fund lease-up costs, the rescue investor might get a priority return of 15%+ and significant control rights. If the borrower eventually refinances or sells at a higher value, the rescue capital is taken out first (often with accrued pref and maybe a fee), and only then does any remaining value accrue to the original equity holders. In essence, rescue capital dilutes or replaces part of the original equity – it’s a lifeline, but a costly one.
However, the rescue capital wave has been slower to materialize than many anticipated (yieldpro.com, yieldpro.com). One reason is the bid-ask spread between what stressed owners are willing to pay and what rescue investors demand. As of mid-2024, “what the borrowers say they need and what the funds say they need for return aren’t matching up,” noted one rescue capital fund manager – with owners hoping for cheaper money and rescue funds often insisting on high-teen IRRs (18–22%) that many deals can’t support (yieldpro.com). Additionally, lenders have in many cases extended and pretended, giving borrowers more time rather than forcing a recapitalization. Banks and senior lenders, wary of taking losses or foreclosing, have been “bending their own rules to give over-leveraged borrowers more time”, even on loans that have technically matured (yieldpro.com). This has reduced the immediate volume of rescue deals, as some troubled assets limp along with temporary loan extensions. Nonetheless, market experts widely agree that rescue capital opportunities will continue to arise as loans inevitably come due and cannot be kicked down the road indefinitely (yieldpro.com). Indeed, by 2025, we are starting to see a “trickle” of distress turning into more deal flow – not a tsunami of foreclosures, but a steady stream of recapitalizations and note sales (credaily.com).
Alongside pure rescue plays, we also see senior-subordinate structure innovations designed to stave off distress. For example, some lenders are structuring “hope notes” or accrual tranches – splitting a loan into an A-note (paying current interest) and a B-note (which might accrue interest or have contingent payment, essentially functioning like an embedded mezz piece). Others arrange preferred equity participations at loan origination: a senior lender might require the sponsor to secure a pref equity investor to sit behind the loan, thus lowering the loan’s effective LTV. This way the senior loan looks conservative, and the pref equity absorbs the risk if performance falters. These creative structures are all forms of capital stack engineering aimed at addressing the financing gap and sharing risk. They reflect a financing ecosystem in flux: traditional senior debt alone often can’t carry the load at today’s interest rates, so deals are being bolstered by any means necessary – whether that’s a family office stepping in with a junior tranche or a debt fund offering a unitranche loan that wraps senior and mezz into one.
The implications for existing owners and new investors are significant. Original equity investors (including LPs) in deals now facing rescue capital infusions may see their positions diluted or subordinated. A rescue capital provider might negotiate preferential treatment that effectively strips value from the common equity unless the asset dramatically appreciates. On the flip side, for investors with dry powder, this environment presents a chance to “pick off” high-quality assets through recapitalization (credaily.com). We have seen savvy players with liquidity partner with banks to insert capital into struggling projects on favorable terms – for instance, by buying the distressed note at a discount or providing new funds in exchange for an ownership stake. Such deals can generate outsized returns if the asset recovery is successful. But they also carry “loan-to-own” risk dynamics: if the asset doesn’t recover, the rescue investor may end up foreclosing or owning a property they hadn’t planned to. Thus, thorough due diligence and structuring (e.g. requiring additional collateral or governance rights) is essential for anyone providing rescue capital. In summary, rescue capital and other senior-subordinate innovations are both a symptom and a cure for capital stack compression – they arise because equity cushions are gone, and they provide a stopgap solution, albeit one that reorders who bears the risk going forward.
Implications for IRR Modeling and Refinancing Risk
The compression of the capital stack in 2025 has far-reaching consequences for how investors model returns and assess risk. Internal rate of return (IRR) modeling for real estate projects must now contend with far more complex capital waterfalls. Instead of a simple split between senior debt and equity, many pro formas need to account for multiple tranches each with its own return requirement and priority. For example, a development deal might have a senior loan at 7% interest, a mezzanine loan at 12%, a preferred equity layer targeting 15%, and then the sponsor’s common equity hoping for 20%+. The presence of these additional layers means that the common equity’s IRR is now highly sensitive to performance – and may be capped or wiped out unless the business plan is executed flawlessly. If the project’s cash flows or sale proceeds only suffice to pay off the debt and the preferred return, the common equity could end up with little to no return (or even lose its invested capital). Thus, sponsors and LP equity investors must build models that realistically account for these waterfall hurdles and perhaps lower their expectations of sky-high IRRs, given the heavier claims senior to them.
One clear outcome of higher debt service and preferred return burdens is that project cash flows are under much more pressure. Many investors are facing neutral or even negative leverage – situations where the cost of debt exceeds the property’s current yield, meaning adding leverage reduces equity returns rather than enhances them. The rapid interest rate increases of 2022–2023 led to exactly that scenario in many cases: cap rates (property yields) rose only gradually even as borrowing rates spiked, leading to a period of negative leverage that weighed down borrowers (brevitas.com). Even as of early 2025, after the Federal Reserve executed a few rate cuts, borrowers continue to grapple with thin or negative leverage spreads – all-in financing costs remain above property yield levels in many sectors, leaving little margin for error in cash flow coverage (bradvisors.com). This means when underwriting deals, debt coverage ratios are tight and interest reserves or contingency funds are often needed to get lenders comfortable (credaily.com). From an IRR modeling standpoint, sponsors now routinely model scenarios with higher exit cap rates and slower NOI growth to be safe, and they check what happens to equity returns if an extra year or two of hold is needed (since refinancing might not be available at favorable terms right when you want it).
Refinancing risk has become a paramount concern in this era. With so much short-term and floating-rate debt coming due (recall that massive maturity wave of loans originated 2018–2020 that are now hitting maturity), investors must plan for how to take out those loans under very different market conditions. Many bridge loans that were underwritten with an expectation of refinancing into a low-rate permanent loan have had to be extended or restructured. Now, looking forward, any deal structured with a mezzanine or pref component also typically has a defined term (often 2–5 years), meaning the clock is ticking for the sponsor to either sell the asset or refinance into more conventional (and hopefully cheaper) financing. If interest rates stay elevated longer than anticipated or capital market liquidity dries up, there’s a risk that refinancing options in 2025–2026 could be limited or costly. This is particularly worrying for those deals that have accrual structures – e.g. a preferred equity that is accruing a 15% return. The longer it goes unpaid, the larger the claim that accrues, and by maturity the required payoff could be substantially higher than the original principal. Sponsors must model these accrued payoffs carefully to ensure that an eventual sale or refi can cover them. Otherwise, come refinancing time, the junior capital could effectively eat the equity (if property value hasn’t grown enough).
Investors are responding to these risks by demanding more conservative assumptions and buffers in deal projections. LPs and investment committees in 2025 often insist on seeing stress tests: what happens to IRR if exit cap rates are, say, 50–100 basis points higher than base case? What if the refinance interest rate in 2 years is not 5% as hoped but 6% or 7%? Given global economic uncertainty, these are very real possibilities. Another implication is that hold periods may extend – some business plans are now modeling 5-7 year holds (vs. the typical 3-5) to ride out the high-rate environment and allow more time for value creation to materialize. This of course affects IRR (longer holds can reduce IRR even if absolute profit is similar) and requires patience from investors.
From the perspective of risk allocation, the compressed capital stack concentrates risk in the lowest tranche of true equity. The common equity – often the sponsor and maybe an LP co-invest – is now a smaller piece of the pie, but it bears all the downside risk until it’s wiped out. The layers above (pref equity, mezz debt) have senior claims and thus somewhat insulated returns, but they are not risk-free either. If a deal underperforms just enough that the common equity is wiped out and cannot fully cover the pref, the preferred equity investor will start to suffer losses next. Because equity cushions are thinner, the probability of hitting those loss thresholds is higher than it was in a more conservatively leveraged deal. This is why, for instance, mezzanine lenders are charging higher spreads and carefully underwriting the asset value – they know that with an 80-85% combined loan-to-value, even a 15-20% drop in value puts their capital at risk. Preferred equity providers similarly look at debt yield and coverage ratios to ensure the asset can pay their pref in most scenarios. They often negotiate covenants that trigger intervention rights if performance slips, effectively allowing them to step in before their position is completely jeopardized.
The silver lining is that all participants are now forced to be more disciplined about underwriting and monitoring. Gone are the days (for now) of aggressive pro formas relying on cheap debt and endless rent growth. Lenders and investors are pressing for realistic exit valuations and cautious growth projections. In an odd way, the adversity of capital stack compression is bringing more rigor to the market. Projects that don’t have a clear path to creating value (through lease-up, redevelopment, operational improvement, etc.) simply won’t attract financing, because there’s no longer a rising market tide or easy money to paper over weaknesses. For those deals that do proceed, the sponsors need to be prepared with contingency plans – for example, having extension options or rate cap hedges in place for floating-rate debt, or lining up multiple refinancing sources well ahead of loan maturities. The cost of capital is now a central factor in project feasibility. Many investors are accepting that lower leverage (and thus lower potential IRR) might be prudent in some cases, even if it means bringing more equity. Others are structuring tiered promotes or waterfall adjustments where the sponsor’s share of profits increases if returns hit certain high benchmarks – essentially giving the sponsor a way to still achieve a good upside if things go exceedingly well, but not burdening the deal with expensive mezz if it’s not absolutely necessary. In summary, IRR modeling in 2025 must be robust and multi-dimensional, capturing the interplay of various capital stack elements, and factoring in the very real refinancing and exit risks on the horizon. Investors who fail to do so may find that their realized returns fall short of projections due to the unforgiving math of a compressed capital stack.
Macroeconomic and Geopolitical Influences on Capital Stacks
No real estate market exists in a vacuum, and today’s capital stack dynamics are deeply influenced by global macroeconomic and geopolitical forces. In fact, the U.S. commercial real estate market in 2025 is at the confluence of several significant global trends: diverging central bank policies, volatile currency movements, and shifting cross-border investment flows. These factors impact both the availability of capital for real estate and the risks that investors must account for when structuring deals.
First, consider the role of interest rate policy divergence. The U.S. Federal Reserve led the charge in raising rates aggressively in 2022–2023 to combat inflation, which had worldwide effects. By mid-2025, the Fed has at least paused its hikes and even begun modest easing, whereas other economies are on varied trajectories – some central banks (like the European Central Bank) lag the Fed’s cycle, and a few emerging markets that tightened earlier have already started cutting rates to support growth (brevitas.com, brevitas.com). This divergence creates a push-pull in global capital: higher U.S. rates attracted capital into dollar-denominated assets, pulling money out of riskier markets, whereas once the Fed signals cuts, we typically see capital begin to flow outward in search of higher yields abroad (brevitas.com). In 2022–23, for example, rising U.S. yields contributed to capital outflows from emerging economies and a strengthening dollar; investors were effectively rewarded for parking money in the U.S., and many “shed risky foreign investments” amid the rate hikes (brevitas.com). Now in 2024–25, as the Fed’s stance has softened slightly, some of those funds are testing the waters internationally again.
For U.S. commercial real estate, these global interest rate moves have dual impacts. On one hand, U.S. properties saw valuations adjust downward as cap rates rose under pressure from higher debt costs – a direct consequence of Fed policy tightening (brevitas.com). On the other hand, once it became evident that the Fed was nearing a peak and inflation was cooling, transaction activity began to recover both domestically and globally. In fact, the start of 2025 has seen a notable rebound in investment volume and cross-border deals. According to JLL, global commercial real estate investment in Q1 2025 was up 34% year-over-year, and cross-border investment surged by 57% – the highest first-quarter level since 2022 (jll.com, jll.com). This jump in cross-border flows shows how “improvement in capital markets dynamics” and clarity on rates can normalize investor activity (jll.com). Simply put, once investors believe interest rates are stabilizing (even at a higher level than before), they feel more confident deploying capital, including across borders. The U.S. remains an attractive destination for many international investors due to its relative economic stability and the repricing that has occurred (U.S. commercial property values are in many cases 10–20% off their peak, which can be seen as a buying opportunity for long-term foreign capital).
However, geopolitical uncertainty adds a layer of caution. The global economic narrative in 2025 is dominated by unpredictability around trade policy, conflict, and political shifts (jll.com, jll.com). Issues such as trade disputes between major economies, the war in Ukraine and its effect on energy markets, and other regional tensions all influence investor sentiment. They can cause flight-to-quality movements – for example, during periods of acute geopolitical risk, investors often flock to safe havens like U.S. Treasuries or core real estate in politically stable countries. This can actually benefit U.S. real estate: a volatile world makes a New York office tower or a Los Angeles apartment portfolio look relatively secure, assuming the currency risk can be managed. Indeed, Europe saw strong inflows in late 2024 from U.S. investors, partly because the U.S. rate peak and slight easing created an opening – Europe was the largest recipient of cross-border CRE capital in late 2024 with $21.6B of inflows (up 10% YoY), largely from U.S. investors rotating into European assets (brevitas.com). That reflects a form of capital rotation where, once the dollar’s rise paused, Americans went bargain-hunting abroad. Conversely, Middle Eastern and Asian investors flush with capital have been eying the U.S. and Europe for diversification, especially as oil-rich nations benefited from high energy prices and seek to reinvest surpluses into hard assets overseas.
Currency risk is a crucial factor when integrating global capital into U.S. deals (or vice versa). The strong U.S. dollar in recent years has been a double-edged sword. A higher Fed rate generally strengthens the dollar, which means foreign investors’ returns in their home currency can be weaker when converting out of USD (brevitas.com). For example, a European or Asian investor buying U.S. property has to consider that if the dollar depreciates by the time they exit, they could lose a chunk of their gains on the exchange rate. Conversely, if the dollar remains strong or the foreign currency weakens further, the investor might gain a currency boost. In 2022–2023, many emerging market investors experienced this “currency drag” – their local currencies fell against the dollar, reducing their effective returns or making new U.S. acquisitions more expensive in local terms (brevitas.com). By 2025, if the Fed is slowly easing and the dollar rally is cooling, some of that pressure is lifting. But currencies remain volatile. Smart cross-border investors now routinely hedge currency exposure for at least the medium term, despite the cost, to lock in the effective return in their base currency. Likewise, U.S. investors going abroad must account for currency swings – a divergence in interest rate paths (say the U.S. cutting while another country holds rates high) could weaken the dollar and benefit U.S. investors overseas, or the opposite could strengthen the dollar and erode foreign asset returns.
Another aspect of macro divergence is relative yield spreads between markets. If, for instance, European interest rates stay lower than U.S. rates, European core real estate might have a lower cost of debt and potentially lower cap rates than the U.S. Does that make Europe more attractive? Perhaps for some, but one must also weigh growth prospects and currency expectations. In 2025, the global theme is fragmentation – different regions are not moving in lockstep. The IMF has noted growing disparities: some economies are accelerating while others face slowdowns (janushenderson.com). China’s growth has sharply slowed by some accounts (jpmorgan.com), which can affect its outbound real estate investment (Chinese investors were big players in U.S. real estate a few years ago, but have pulled back due to capital controls and domestic issues). Meanwhile, oil-rich countries in the Middle East have excess capital and are investing globally, including in U.S. real estate, seeking stable long-term returns.
For U.S. dealmakers, all this means the source and cost of capital can vary dramatically depending on global trends. A family office from, say, South Korea or Singapore may have a different return hurdle and risk appetite than a domestic pension fund – partly due to their home rate environment and currency outlook. In an environment where global debt markets are largely liquid and supportive (as JLL notes, debt markets have been a backbone of the real estate recovery, providing liquidity to deals worldwide) (jll.com), sponsors have the opportunity to tap into cross-border capital flows. We have seen growing partnerships where foreign investors provide mezzanine or preferred equity capital into U.S. projects, attracted by the strong legal system and asset stability, while U.S. sponsors benefit from diversified funding sources. Conversely, U.S. capital is also chasing opportunities abroad where pricing dislocations are significant – for example, certain European office markets or Asian hospitality assets that have lagged in recovery.
Global capital rotation also reflects investor preference changes: in a high-rate world, some institutions prefer fixed-income or debt-like investments over equity. Real estate debt, as discussed, has become more popular. We see global investors allocating more to private credit funds that provide real estate loans. This is indirectly influencing the capital stack by ensuring plenty of capital for mezzanine and pref equity, potentially keeping those spreads “tighter” (i.e. competitive) than they otherwise might be. If too much money chases those investments, yields could compress. However, so far the risk and complexity of these deals have kept yields fairly elevated.
In summary, the macro/geopolitical context of 2025 adds both opportunities and challenges for CRE capital stacks. Opportunities in that cross-border capital is flowing again – global investment volumes are rising and many investors view the post-value-correction real estate landscape as fertile ground (jll.com, jll.com). Challenges in that divergent interest rates and currencies add extra layers of risk to manage. A savvy sponsor or investor needs to stay attuned to Fed meetings, ECB policy signals, trade news, and even geopolitical risk indicators because these can swiftly alter borrowing costs or capital availability. For instance, a sudden flare of geopolitical conflict might drive treasury yields down (flight to safety) which could lower mortgage rates briefly – a window to lock in financing. Or a surprise rate hike in Europe while the U.S. holds steady might strengthen the dollar, affecting foreign investment calculus. This dynamic environment means strategic flexibility is key. Those who can dynamically adjust – hedging when needed, choosing financing from the most favorable sources globally, and timing capital moves with macro trends – will fare better in navigating the compressed capital stack era.
Strategic Recommendations for Sponsors and Investors
Adapting to the era of capital stack compression requires a strategic, proactive approach. Below are key recommendations for deal sponsors and investors looking to navigate the risk-reward tradeoffs of 2025’s compressed capital stacks:
Bolster Equity and Emphasize Quality: In a market with thinner equity cushions, quality of equity matters more than ever. Sponsors should consider contributing a bit more true equity (or bringing in strong JV equity partners) to reassure lenders and pref/mezz providers that there is a meaningful buffer. Deals with a strong sponsor co-invest and a solid track record are finding better financing terms (credaily.com). Family offices and LPs might prioritize sponsors who demonstrate “skin in the game” and financial strength, as lender scrutiny on this is intense. A slightly larger equity slice can be the difference between securing financing or not, and it also gives sponsors more control and staying power if things go awry.
Leverage Alternative Capital Wisely: Mezzanine debt and preferred equity are useful tools, but they should be employed judiciously. Sponsors ought to shop around and negotiate terms carefully – for instance, seek flexibility to prepay subordinate debt without massive penalties once permanent financing becomes cheaper, or negotiate the right to buy out a pref equity partner if you refinance. Use mezz/pref capital as a bridge, not a crutch: structure it with clear exit strategies (e.g., a planned condo sell-out or a refi upon stabilization) and avoid stacking multiple expensive layers if not absolutely necessary. For investors providing this capital, perform rigorous due diligence on the asset and sponsor, and structure protections (covenants, cure rights, maybe even warrants or upside sharing to align interests) (citrincooperman.com). Both sides should ensure that the intercreditor agreement (between senior lender and junior capital) is well understood and provides remedies in a downside scenario.
Stress-Test IRR Models and Returns: Conservative underwriting is non-negotiable. Sponsors and investors should run deal models at higher interest rates and cap rates than the base case, and examine the impact on equity IRRs after satisfying all debt and pref equity returns. Make sure the deal still works with, say, a 0.5% increase in exit cap or an extra 6–12 months of carry costs. If the project only pencils out under rosy assumptions, reconsider the leverage or price. It’s better to structure a deal for success under average conditions than to stretch for an optimistic IRR that likely won’t materialize under compressed spread conditions (bradvisors.com). Remember that negative or neutral leverage can sneak up on you – if the going-in cap rate is barely above (or below) the loan constant, adding debt won’t boost returns (brevitas.com). Thus, focus on deals where you can create yield (through improvements or lease-up) rather than relying on high leverage for returns.
Proactively Manage Refinancing Risk: With a wall of maturities coming, early planning for refinancing or exit is critical. Don’t wait until six months before a loan maturity to line up options. Sponsors should engage with lenders 1-2 years in advance of major debt maturities on large assets, exploring extension options or refinancing with alternate lenders (debt funds, life insurers, etc.). Consider securing rate locks or hedges if you believe rates might rise by the time of refinancing. If a project has a mezzanine or pref piece maturing in, say, 2026, start negotiating now for an extension or takeout – possibly even raising additional equity now to pay it down some, which could be easier than a last-minute recap under duress. Investors should favor business plans with multiple exit options (sale, refinance, or even partial asset sell-off) to avoid being cornered. Additionally, maintain open communication with your capital providers; if performance is behind plan, it’s often better to restructure before an actual default. The mantra is “no surprises” – address refinancing challenges head-on and secure your lifelines early.
Diversify Capital Sources: In a more fragmented global financial environment, savvy real estate operators diversify where they get capital. Cultivate relationships across banks, debt funds, insurance companies, and international investors. Each source has different cycles and criteria – for example, local banks might still lend on that neighborhood retail center when CMBS won’t, or a Middle Eastern sovereign fund might provide preferred equity on a multifamily portfolio that U.S. banks deem over-leveraged. By keeping multiple financing channels open, you can tap the most competitive capital for each layer of the stack. We see, for instance, life insurers stepping up with creative construction-to-perm loans (prea.org), and private lenders doing high-leverage bridge loans – know who is active in your asset class. For foreign investors, consider club deals or co-investments to team up with local partners who have on-the-ground expertise, thereby mitigating some perceived risk and possibly accessing financing you couldn’t alone.
Hedge and Manage Currency Exposure: If you are a foreign investor in U.S. real estate (or a U.S. investor raising capital abroad), currency fluctuations can make or break your returns. Incorporate currency risk management into your strategy. This could mean using forward contracts or options to hedge a portion of your expected cash flows or equity repatriation. At the very least, model your returns under different FX scenarios (e.g., what happens if the U.S. dollar declines 10% over your hold period?). Many global investors learned in recent years that a strong dollar can erode profits (brevitas.com) – so now the best practice is to treat currency as another line item in the underwriting. If hedging is too costly, you may require a higher entry cap rate to compensate for the unhedged risk. And if you’re a U.S. sponsor taking on foreign equity, be mindful of their currency concerns; you might structure the partnership to mitigate these, such as distributing in USD and letting them decide hedges, or even pricing the deal in a way that accounts for expected currency shifts.
Focus on Resilient Asset Fundamentals: With thinner margins for error financially, the underlying real estate asset’s performance is crucial. Prioritize investments in property types and markets with durable demand drivers and growth potential, as these are more likely to outperform your underwriting and provide a buffer if financing costs stay high. For example, multifamily and industrial properties have shown strong fundamentals and continued investor interest (bradvisors.com), making them somewhat safer bets for achieving rent growth or occupancy targets. In contrast, riskier assets (like speculative office developments in struggling downtown markets) might not afford any cushion if leasing falls short – a small miss can cascade through a leveraged stack. Also, invest in asset management: drive NOI through cost control, lease-up, or improvements. A property that can steadily increase its income will effectively deleverage the capital stack over time, reducing risk for all stakeholders. By closing the gap between cap rate and interest rate through NOI growth, you can flip negative leverage to positive, benefiting equity returns in the long run.
Stay Nimble and Opportunistic: Finally, remain ready to capitalize on dislocations – but with caution. In compressed capital stack times, there will be distress-driven opportunities: note sales, recapitalizations, or forced asset sales where you can step in with capital. If you’re an investor with liquidity, you might serve as rescue capital or buy assets at a discount. These can be lucrative, but structure any opportunistic deal for downside protection. Insist on senior position if possible, or a substantial equity cushion beneath you (credaily.com). Perform extra due diligence, because distressed assets often have surprises. On the flip side, if you’re a sponsor facing trouble, be open to bringing in fresh capital early – don’t wait until you’ve burned through reserves. An investor who comes in now with rescue funds might accept a lower return (or less control) than one coming in at the 11th hour when you’re out of options. In all cases, nimbleness also means monitoring macro trends and being ready to adjust strategy – for example, if the Fed unexpectedly cuts rates faster and debt becomes cheaper, be prepared to refinance or lock in long-term debt quickly. If geopolitical events shake up capital markets, maybe you delay a sale or conversely accelerate a capital raise before conditions change. Flexibility and quick decision-making are assets in themselves during uncertain times.
By implementing these strategies, sponsors and investors can better align their approach with the realities of 2025’s compressed capital stack environment. The key is to be neither overly timid nor recklessly aggressive, but to strike a balance: respect the higher risk by adding safeguards and realism, while still seizing opportunities that arise from dislocation. The firms that navigate this period successfully will likely emerge with stronger relationships (lenders and equity partners forged in tough times tend to stick together) and potentially outsized gains once the market fully normalizes.
Conclusion
The capital stack compression we’re witnessing in 2025 is both a challenge and an opportunity for the real estate industry. It forces all parties to fundamentally re-evaluate how risk and reward are divided in a deal. While the shrinking of equity cushions and proliferation of high-cost mezzanine capital raise risks, they also reflect a market finding a new equilibrium after a period of upheaval. By staying disciplined – in underwriting, structuring, and macro-awareness – investors and sponsors can continue to achieve their objectives even in this complex environment. The era of easy money is gone, but an era of creative finance and strategic capital allocation is well underway. Those who adapt to these new norms, leveraging the recommendations outlined above, will not only protect themselves in the present, but also position their portfolios to thrive as the cycle eventually turns.
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Sources: bradvisors.com, citrincooperman.com, prea.org, credaily.com, yieldpro.com, brevitas.com, jll.com, jpmorgan.com, janushenderson.com
Disclaimer: This article is for informational purposes only and does not constitute financial or investment advice. All investing and lending involves risk, and readers should perform their own due diligence or consult with professional advisors before making decisions. The views expressed here are based on market trends and sources as of the date of writing, and future conditions may change