Understanding the Capital Stack: How Physicians Can Diversify with Real Estate

For physicians looking to diversify their portfolios, passive real estate investment offers a compelling pathway to balance risk while achieving a blend of income and total return potential. However, even within the real estate crowdfunding space, there are numerous options, offering varying risk/return profiles. Real estate investing is getting easier and more accessible. However, navigating the current landscape of passive real estate options can still feel daunting, especially when juggling a demanding career. One key concept to understand when exploring real estate investing is the “capital stack.”

This is a term that may sound technical but can be instrumental in helping investors choose the right investments. Diversifying across the real estate capital stack may be crucial to aligning your real estate portfolio with your overall long-term goals.

In this article, key resource EquityMultiple and I will break down the real estate capital stack and explore how each layer offers distinct opportunities and risks. We’ll also look at how EquityMultiple’s curated investments make it easier for physicians to diversify across the capital stack in ways that fit different risk tolerances and return preferences.

If you are invested or thinking of investing in passive real estate investments, this is a MUST read!

What is the Real Estate Capital Stack?

The capital stack refers to the layers of financing used to fund a real estate project. Each layer—ranging from debt to equity—has a different level of risk and return. Understanding this hierarchy is crucial. It defines who gets paid first in the event of a cash flow or liquidation. Here’s a breakdown of the capital stack from most to least secure:

Senior Debt – The most secure layer
Mezzanine Debt – Higher risk but often with higher returns than senior debt
Preferred Equity – Lower in the stack than debt but often with contractual income
Common Equity – The highest risk but offers the greatest potential upside

Let’s delve into each of these layers and see how they fit different investment goals, especially for physicians who want flexibility, cash flow, and long-term wealth accumulation.

Senior Debt: The Foundation of Stability

Senior debt is the safest part of the capital stack because it is secured by the real estate asset itself. In practical terms, if a property does not generate enough cash flow, senior debt holders are the first to be paid back, even in the case of foreclosure.

A real estate operator (the sponsor or GP raising capital for their investment) will often seek a senior loan to supplement a loan from a traditional lender (bank, insurance company, or CMBS) to “bridge” them to a point where they can refinance at a lower rate. This dynamic creates the potential for attractive fixed returns for investors. Senior CRE debt is often referred to as “real estate private credit.” With the Fed’s benchmark rate still elevated from prevailing rates up until 2022, the rate that private lenders can command — and hence the rate of return that individual passive investors can enjoy — may remain attractive for some time.

For a physician investor looking for low-risk investments, senior debt is appealing. This is because it provides relatively stable returns, typically in the form of interest payments. The downside is that senior debt investments offer lower, capped returns than other parts of the capital stack. Returns are usually in the range of 8-12% annually.

With senior debt investments, physicians can enter real estate with peace of mind in a secured position. It’s an ideal choice for those prioritizing capital preservation over high returns.

Key Benefits of Senior Debt for Physicians:

Lower risk compared to other real estate investment types
Predictable, income-focused returns through regular interest payments
Secured investment with the real estate asset as collateral

Key Considerations:

How creditworthy is the borrower?
What leverage are the sponsors holding in the overall capital stack? In other words how much cushion is there from equity investors who have lower payment priority.
How attractive is the rate of return versus other short-term, relatively safe investments?

Mezzanine Debt: Bridging Stability and Yield

Mezzanine debt occupies the next layer in the capital stack and serves as a bridge between senior debt and equity. This type of financing typically offers fewer protections than senior debt. This means it carries more risk but also offers higher potential returns, often in the range of 10-14% annually. Mezzanine debt holders are only paid after senior debt obligations are met. But they receive priority over equity investors.

For physicians looking to balance risk with a slightly higher yield, mezzanine debt could be a viable option. By incorporating mezzanine debt into a diversified portfolio, physicians can achieve a favorable risk-return balance—enjoying income potential without the higher risk associated with equity investments.

Key Benefits of Mezzanine Debt for Physicians:

Higher return potential than senior debt while retaining moderate risk
Regular income potential through interest payments
Intermediate risk with a payment priority over equity investments

Key Considerations:

What investor protections (if any) are in place in case of default?

Preferred Equity: Enhancing Cash Flow and Return Potential

Preferred equity is a hybrid layer in the capital stack. It carries a higher level of risk than debt but provides a more stable return profile than common equity. Investors in preferred equity receive dividends or interest payments before common equity holders, and, in many cases, preferred equity offers an income-focused return with current preferred return in the range of 10-14%. In many cases, preferred equity investors receive an ‘accrued preferred return’. This acts like a sweetener at exit. If the deal is performing well, investors can earn extra. Usually this accrued portion amounts to a few percentage points, taking the overall return to the range of 12-17%.

This position appeals to physicians looking for a mix of income and moderate risk. It allows them to participate in a project’s success without being fully exposed to its potential downside. EquityMultiple’s preferred equity offerings allow physicians to diversify beyond debt while still maintaining a balanced approach that prioritizes consistent cash flow.

Key Benefits of Preferred Equity for Physicians:

Priority payment over common equity, which reduces exposure to project risk
Income-focused structure with regular dividend payments
Moderate return potential with manageable risk

Key Considerations:

What is the breakdown between current and total (accrued) preferred return?
Is the return profile appropriate relative to senior or mezzanine debt positions in the capital stack?

Common Equity: Maximizing Long-Term Growth

Common equity, or JV (joint venture) equity, sits at the top of the capital stack. It carries the most risk and the highest potential for reward. Equity holders are only paid after all debt and preferred equity obligations are met. This means they take on the most significant risk. However, they also have the greatest opportunity for returns, particularly if the property appreciates or sells at a high value.

For younger physicians or those looking for longer-term, growth-focused investments, common equity can offer a powerful opportunity to build wealth. Returns in common equity typically expressed as an IRR or internal rate of return. Here is an in depth review of what IRR measures and means. These cash flows are typically a blend of distributions from rent and profits at exit (the sale of the asset). Unlike debt and preferred equity positions, these distributions from rent (the mid-stream cash flow) are not contractually obligated. There tends to be much more variance in the projected and realized returns for equity investments. The net IRR to passive (LP) investors tends to be above 18%. But can be much higher if the deal performs well.

Many factors can impact performance of equity investments, including the interest rate environment, the local economy, and asset-specific factors like the success of marketing and leasing of a repositioned property.

The return structure of equity investments can be quite a bit more complex than that of debt and preferred equity investments

Typically passive investors receive a “return hurdle.” This is a threshold level of return before the sponsor can pay themselves further profits. The sponsor usually receives an outsized share of profits once passive (limited partner) investors are paid back. This structure is to incentivize sponsors for achieving high returns. In many cases, this “promote” is subject to several tranches. Above a certain level of deal-level return, the split of profits between the sponsor (GP) and passive investors (LP) may shift. This structure is often referred to as the “return waterfall.”

Given the relative complexity, variance of potential outcomes, and risk factors, real estate equity investments make sense for those with a baseline knowledge of real estate markets, and/or the capital and investment horizon to take on more significant risk factors (alongside the higher return potential). Working with a platform like EquityMultiple can benefit individual investors, who are represented as part of a larger aggregate position in the deal.

Investing in common equity through EquityMultiple provides physicians a way to participate in substantial upside potential with institutional-grade assets and sponsors, enabling them to capitalize on high-growth opportunities within the commercial real estate sector.

Key Benefits of Common Equity for Physicians:

Greatest potential for long-term growth and wealth accumulation
Higher return profile than other investment layers
Ability to participate in property appreciation and exit profits

Key Considerations:

How experienced is the sponsor, particularly in executing this type of investment strategy?
What is the promote and waterfall structure, and is it appropriate given the level of risk and complexity in the deal?
What is the return horizon and what are the overall risk factors?
What is the “investment strategy” (core, core-plus, ground-up development, value-add, etc.) and is the IRR target appropriate given that strategy?

How Curated Investments Can Help Physicians Diversify Across the Capital Stack

EquityMultiple offers curated real estate investments across all levels of the capital stack, enabling physicians to build a diversified portfolio that aligns with their individual goals and risk tolerance. By investing through EquityMultiple, physicians gain access to institutional-grade opportunities previously reserved for large investors, with investments available in senior debt, mezzanine debt, preferred equity, and common equity.

Here’s how EquityMultiple’s approach can help physicians make the most of their real estate investments:

Access to Diverse Deal Types: Whether a physician seeks the stability of senior debt, the balanced yield of mezzanine debt, the income-focused structure of preferred equity, or the growth potential of common equity, EquityMultiple provides options across the capital stack.
Transparency and Due Diligence: EquityMultiple vets each deal meticulously, offering transparency that allows physician investors to make informed decisions without needing to be real estate experts themselves.
Flexible Minimums: Physicians can start with smaller investments, gaining exposure to various parts of the capital stack without overextending their portfolios.
Investor services: you don’t have to be a super knowledgeable real estate investor to benefit from passive, fractional real estate investments. However, you should be able to get answers to your questions, get comfortable with any particular investment choice, and feel like you have a partner in your investment decisions. EquityMultiple strives to provide these benefits via a dedicated investor relations team.

Building a Balanced Real Estate Portfolio as a Physician

Real estate investing can be an effective way for physicians to diversify, achieve financial stability, and work toward long-term wealth creation. By understanding the capital stack and selecting investments aligned with their personal goals, physicians can create portfolios that provide both income and growth potential.

The options within the real estate capital stack are somewhat analogous to stocks and bonds and the “100 minus your age” rule. If you are earlier in your investing journey and can tolerate some level of risk, you may want to tilt your real estate portfolio toward JV equity investments. As you near retirement, you may want to allocate more heavily to debt and preferred equity investments, where you may benefit from shorter terms, payment priority, and more stable fixed rates of return.

EquityMultiple’s platform makes this process accessible, allowing busy professionals to invest in institutional-quality deals with confidence. Whether you’re just starting or looking to refine your existing portfolio, exploring the capital stack can help you unlock real estate’s potential to enhance your financial health—without requiring a deep dive into real estate management.

By taking the time to understand the capital stack and considering various investment types, physicians can leverage real estate as a strategic asset class in their overall wealth-building strategy.

Remember, no passive investment is totally “passive.” If investing passively, you need to educate yourself and understand every aspect of what you are getting into. And the real estate capital stack is part of that!

Here are some addition resources to help you on your real estate journey:

What do you think? Do you favor passive or active real estate investing? What part of the real estate capital stack have you invested in? Let me know in the comments below!