Understanding the First Loss Position in a Commercial Real Estate Capital Stack

When Alex considered financing his first mixed-use development, lenders asked about his first loss position. Why? In every commercial real estate transaction, the capital stack—senior debt, mezzanine debt and equity—defines who eats losses first. Understanding how the first loss position works is key to structuring bankable deals, optimizing loan-to-value ratios and protecting lenders from downside risk.

What Is a First Loss Position?

The first loss position is the tranche of capital that absorbs initial losses if property values drop or cash flow falls short. Typically held by the sponsor’s equity tranche(common equity or preferred equity), it gives confidence to senior lenders that a buffer exists before their senior debt is at risk. Think of equity as a shock absorber under the rest of the stack.

How the Commercial Real Estate Capital Stack Fits Together

• Senior Debt – Highest priority repayment, lowest interest rate, highest lender security.
• Mezzanine Debt – Subordinate loan with higher yield, secured by equity interests, sits between senior debt and equity.
• Preferred Equity – Fixed‐return equity tranche without voting rights, junior to debt but senior to common equity.
• Common Equity – True first loss position, variable returns, full upside participation and voting control.

Why Sponsors Must Commit Equity

Without a meaningful first loss position, why would a lender underwrite a 75% or 80% LTV loan? Sponsors with skin in the game align their incentives: they manage property operations, lease up vacancies and curb cost overruns. Ask yourself: would you lend $8 million on an $10 million asset if the borrower had no equity at risk?

Examples and Storytelling

Consider a 100-unit apartment tower. A bank provides $30 million senior debt on an 80% LTV basis. The sponsor contributes $5 million common equity and raises $2 million in mezzanine financing. If rental income drops by 10%, that $7 million in subordinate capital covers the shortfall before the senior lender feels a loss. This real-life scenario illustrates the protective role of the first loss position in maintaining loan performance.

Structuring Your First Loss Position

• Determine appropriate equity contribution to meet lender covenants and target debt-service coverage ratio.
• Layer mezzanine debt or preferred equity to optimize sponsor returns while preserving a buffer.
• Negotiate waterfall priorities and waterfall distribution to ensure clear loss absorption rules.
• Document intercreditor agreements to define rights and remedies of each tranche.

Key Questions to Ask Your Lenders

• What maximum Loan-to-Value ratio do you support with my proposed first loss equity?
• How do you view mezzanine financing versus preferred equity in the capital stack?
• What are the required DSCR and loan covenants tied to the first loss position?
• Can you provide examples of transactions where you accepted a subordinate tranche as loss buffer?