Preferred Equity vs Mezzanine Debt

Investors may not be able to finance a commercial real estate deal on their own. This is driving factor in why many commercial real estate deals are financed using a combination of debt and equity. Investors tend to be familiar with senior loan debt, which is a mortgage that typically finances upwards of 75% of the loan needed to purchase the property, refinance or construct a project. Commercial real estate investors have multiple options available to cover the remaining 20-25% of a project.

Mezzanine debt is a term newer investors in the commercial real estate field may not be familiar with. It may also be called subordinate debt, junior debt, or junior capital. This type of debt is used to supplement other recorded debt, and preferred equity, which is used in lieu of a sponsor taking on additional leverage. Preferred equity and subordinate debt are two important parts of the CRE capital stack.

The CRE Capital Stack

In general, investors typically need multiple funding sources to close on a deal. A deal’s capital stack refers to the specific composition of these different sources. It helps to visualize the stack as a literal stack.

At the top is common equity, the funds that typically command the highest returns but also include the most risk. If a deal goes awry, the common equity holders are usually last to have their investment returned.

At the bottom is senior debt. This is the mortgage loan, or the loan secured by the underlying real estate. If a deal falls apart, the senior debt holder receives their cash back before anyone else. This part of the stack tends to have the lowest risk, but also offers the lowest potential returns.

A variety of financing options exist between these two pieces of the stack, but in general, the “higher” up in the stack, the greater the potential returns and risk. Preferred equity and subordinate debt functionally act similar, as bridges between common equity and senior debt.

What Is the Difference Between Preferred Equity And Mezzanine Debt?

The primary difference between the two is that one acts as debt and the other acts as equity. Both types of financing are hybrids in the sense that they both include some characteristics of debt and equity in the ways they are structured.

Mezzanine financing, however, whether from an investor or institution, is viewed as debt and is next in line to be repaid after senior debt. The recall rights are structured differently than preferred equity. Rates for junior capital can often be two or three times as high as traditional bank debt. In most cases, no principal amortization is required, and junior debt does not take part in back-end profit sharing. It is strictly a risk-mitigated yield play for investors.

Preferred equity is similar to preferred stock in the corporate world. It is subordinate to all debt, like junior debt, but superior to common equity. It also normally holds the third position in the capital stack. Investors tend to use it in three common scenarios: 

  • A mezzanine loan already exists but the sponsor needs additional equity to complete their project.
  • The senior debt provider does not agree to a mezzanine loan.
  • The sponsor is looking to reduce their own equity in a transaction in order to increase liquidity.

Another key difference between the two is that subordinate debt functions more traditionally like senior debt, with foreclosure rights over the real estate property which it holds as collateral for the loan being provided. Preferred equity, on the other hand, retains rights in the event of borrower default, to take over the entity that owns the real estate, not the actual real estate property itself.

Mezz Debt Structure

Mezzanine financing can be structured in a several different ways. In some cases, there is a second mortgage recorded against the property itself as collateral. This structure must be approved by a senior lien holder (i.e., a bank) which is why this type of structure is rarely used.

The second way is to have a senior lender come and use the “A/B” structure, in which they’ll lend up to 85-90% of the capital stack in one loan but will create a blended rate. The senior debt is priced differently than the subordinate debt, but the borrower pays a blended rate across the loan.

A third way, and the most common, is to structure the debt so it takes a subordinate position to the senior loan. Rather than a lien against the property, the borrower creates a “parent of the borrower” entity that actually owns the LLC making the deal. The debt provider is then assigned securities in the parent of the borrower entity, despite this otherwise being a loan.

Preferred Equity Structure

As stated earlier, this is not a loan. Preferred equity instead secures its position in the capital stack by taking a proportional ownership stake in the LLC that owns the property or rights to that ownership in the event of a default. This ownership stake is calculated based on how much the investor contributes relative to the overall equity in the project.

This type of agreement is known as a recognition agreement and is generally negotiated only between the preferred equity investor and common equity partner. The senior debt provider normally has less control over these negotiations, except where loan documents state that the lender has a right to review and approve any preferred equity transactions. Otherwise, their role is fairly limited.

Preferred Equity vs. Mezzanine Debt In Foreclosure

In the unfortunate event of a CRE foreclosure, preferred equity investors and mezz debt lenders have different ownership rights. Both can become indebted to senior lenders if the foreclosure happens before the senior debt is paid off. Both are also able to recoup their investments over time.

Foreclosure – Subordinate Debt: In the event of foreclosure, the mezz lender will be forced to sell the securities of the parent company. Due to this, junior capital lenders have the benefit of a streamlined process that can help remove a defaulting sponsor.

Historically, senior lenders would not allow debt providers to take any action until actual bankruptcy was declared. As time has gone on, however, this has begun to change. Over the last few years, due to regulations enacted following the Great Recession of 2007-2008, most banks are now required to notify the mezzanine investor prior to default so that the lender has the opportunity to work out an arrangement that would help the borrower avoid default.

Foreclosure – Preferred Equity: If a sponsor defaults, preferred equity does not have the benefit of foreclosing on the real estate as a remedy. This tool is reserved for the senior loan provider, which will have the mortgage on the property to use as collateral.

Instead, the investor can dilute the developer or investor’s common equity shares down to zero and take over management of the venture, though this is often only done under extreme circumstances. In less extreme circumstances, the developer may remain in the joint venture, though they would take on a passive role as a limited partner with equally limited rights and authority.

Benefits Of Mezzanine Debt And Preferred Equity

Though they are different in function and are subject to different regulations, mezzanine debt and preferred equity do have some similar benefits.

Less Costly: Both are less costly than issuing common equity, which may have rates as high as 20%. While not as affordable as senior debt, both usually hold a rate of return between 10-15% on average. The rates fluctuate based on the terms.

Fast Funding: If a developer is getting close to the closing date and still hasn’t secured financing, mezzanine debt and preferred equity are both an option for quickly closing that gap. Relying on common equity takes more time and there isn’t always a guarantee that investors will secure all the funding they need.

Tax Benefits: Both forms of CRE financing can enjoy tax benefits depending on how the deal is structured.

How Does The IRS Treat Each Type Of Financing?

Developers like to use mezzanine debt because they can write off the interest paid in their end-of-year tax returns, since lenders claim it as ordinary income. Writing off payments with preferred equity is possible, but a bit more complicated. The structure of that deal will determine if tax write-offs are possible. For a general partner to write off the interest, the limited partner must agree to claim the interest as debt, not income.

What Does This Mean For Investors? Choosing mezzanine debt, preferred equity, or both to secure funding for a commercial real estate deal varies by investor. In many cases, wanting to close a deal as quickly as possible is the reason why developers turn to either one. The lower cost is also a factor and comes with tax advantages.

The important thing investors would benefit from considering is the level of control they are willing to sacrifice in their project. If they’ve done previous business with some preferred equity groups before and have a good relationship with them, that might be the venture they pursue. For investors who are newer to commercial real estate financing and want to maintain their control over the project, mezzanine debt might be the right choice.

Investors should weight the benefits and potential risks of investing in either form of financing. As with any financial agreements, it would benefit the investor to carefully analyze in detail the offerings and work with a sponsor who has a history of building wealth for its investment partners.

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