Mezzanine Debt vs Preferred Equity: A Guide to Commercial Real Estate Financing

Mezzanine debt and preferred equity are two popular financing options for commercial real estate investments. Mezzanine debt is typically used to fill a funding gap between senior debt and equity, and it can offer a higher return on investment than traditional debt.

Mezzanine debt can be structured as a loan or an investment, and it often comes with a higher interest rate than senior debt. This is because mezzanine debt is considered a riskier investment, as it's typically subordinate to senior debt in the event of default.

Commercial real estate investors often use mezzanine debt to bridge the gap between the purchase price and the amount of senior debt available. For example, if a property costs $10 million and the investor can secure $8 million in senior debt, mezzanine debt can be used to cover the remaining $2 million.

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Mezzanine debt and preferred equity are two different types of financing options for real estate investors. Mezzanine debt is structured to provide a higher rate of interest on the loan, often generating equity-like returns with minimal bond-like risk.

Mezzanine debt takes repayment priority over preferred equity and common equity, making it a lower-risk option for investors. However, it doesn't offer the same potential return upside as investing in equity.

Preferred equity, on the other hand, provides a fixed return, such as 9%, and an equity kicker, which can be a percentage of the property's appreciation. In the example provided, preferred equity takes third priority in the capital stack.

Here's a comparison of mezzanine debt and preferred equity:

The choice between mezzanine debt and preferred equity depends on the investor's risk tolerance and return expectations.

Mezzanine debt and preferred equity may seem similar, but they have distinct differences.

Mezzanine debt is a loan to the project, giving lenders different recovery rights than preferred equity investors.

Rates on preferred equity may be slightly higher than mezzanine debt, typically around 1% more.

Mezzanine financing will sometimes have marginally better returns, with rates ranging from 8-12% for existing buildings and 10-13% for development deals.

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Preferred equity investors are more likely to structure a deal where the full interest rate must be paid before any cash flow is distributed to the sponsor or common equity investors.

Mezzanine debt holders may have foreclosure rights over the real property, while preferred equity investors generally have rights over the joint venture but not the real property itself.

Here's a quick summary of the key differences:

Mezzanine debt can be structured in a few different ways, but one common approach is to have it take a subordinate position to the senior loan, where the mezzanine debt provider is assigned securities in the parent entity that owns the LLC doing the deal.

The rates for mezzanine debt can often be two or three times as high as traditional bank debt, and in most cases, no principal amortization is required.

Mezzanine debt takes no part in back-end profit sharing; it is strictly a risk mitigated yield play for investors.

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Debt is a type of financing used in commercial real estate, where a bank or private money loan is utilized as a primary source of capital.

Mezzanine debt is a specific type of debt that falls in the second position in the capital stack, after senior debt financing and ahead of all equity positions.

Mezzanine debt can have rates that are two or three times as high as traditional bank debt, and in most cases, no principal amortization is required.

The biggest hurdle for sponsors seeking mezzanine debt is getting approval from their senior lender, who typically has the upper hand in negotiations.

Mezzanine debt is subordinate to senior debt, and the senior lender generally prohibits certain cures to protect its own position.

In the event of default, the mezzanine lender's rights and cures are outlined in an intercreditor agreement negotiated with the senior lender.

Debt structure is a crucial aspect of understanding how mezzanine debt works. Mezzanine debt can be structured in three main ways: with a second mortgage recorded against the property, an "A/B structure" where the senior lender lends up to 85-90% of the capital stack, or by taking a subordinate position to the senior loan.

In the second structure, the senior lender creates a blended rate for the loan, which is usually around 7% or 8% over LIBOR. This structure is more common than the first one, as it doesn't require the approval of the senior lien holder.

Mezzanine debt can be used to boost potential cash on cash returns to equity investors. For example, if a $3 million multifamily property generates an annual NOI of $240,000, the sponsor can choose a capital stack that includes mezzanine debt to increase the net cash flow.

Here's a breakdown of the capital stack structure:

Mezzanine debt takes a subordinate position to senior debt, which means it's more likely to be repaid if the borrower defaults. This structure is often used in commercial real estate deals where the borrower needs additional financing to complete the project.

Preferred equity is a unique financing tool that offers a mix of debt and equity features. It's not a loan, but rather an equity investment that takes a proportional ownership stake in the LLC that owns the property.

One of the key features of preferred equity is that it provides a fixed rate of return over a specified period of time, along with an upside when the project performs better than expected. This is often referred to as an "equity kicker."

Preferred equity investors and the developer or general partner are joint venture partners, with the general partner responsible for the day-to-day activities of the investment. However, the preferred equity investor has final approval on major decisions.

A preferred equity investor typically receives regular repayments based on an agreed-upon schedule or structured to accrue. In some cases, the general partner may be asked to provide a "bad boy" guarantee, which provides for personal liability against the general partner.

Here are some typical features of a preferred equity investment:

Overall, preferred equity offers a unique combination of debt-like characteristics and equity-like benefits, making it an attractive option for investors and developers alike.

Foreclosure on a mezzanine loan can be accomplished in as little as 45 to 60 days through the Article 9 UCC foreclosure process.

Mezzanine lenders have the benefit of a streamlined foreclosure process that can help remove a defaulting sponsor from the structure. This process allows mezzanine lenders to take control of the project in a relatively short period of time.

Historically, senior lenders would not allow mezzanine debt providers to take action until there was an actual bankruptcy, but this is beginning to change due to regulations enacted as a result of the Great Recession.

Mezzanine debt holders may be given the opportunity to work with the sponsor to cure the default or buy the defaulted senior mortgage at a price equal to the outstanding senior debt.

Preferred equity holders do not have the right to foreclose on the real estate if the sponsor is in default, but they may be able to remove the sponsor from the joint venture and take control of the project.

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In some cases, preferred equity holders may also receive the sponsor's share of equity in the project should the sponsor default.

The effects of foreclosure vary based on the investor's position in the capital stack, and both preferred equity investors and mezzanine debt holders may have the ability to take control of the project in the event of a sponsor default.

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