FREE TRAINING
What is Real Estate Crowdfunding?
Learn how to build wealth and earn passive income in real estate while someone else does all the work.
Preferred Equity or Mezzanine Debt: What's Right for You?
By Adam Gower Ph.D.
Most commercial real estate deals are financed using some combination of debt and equity. People are generally familiar with senior loan debt, which is the mortgage that someone gets to finance upwards of 75% of the loan needed to purchase, refinance or construct a project. Less understood is mezzanine debt, a tool used to supplement any other recorded debt, and preferred equity, which can be utilized in lieu of a sponsor taking on additional leverage.
Mezzanine debt and preferred equity are two important parts of the commercial real estate capital stack. While the two function in somewhat similar capacities, they are structured differently. In this article, we example the differences between mezzanine debt and preferred equity and why a sponsor would consider using one versus the other. Read on for more.
Related: A Starter Guide on Preferred Equity
Get access to our FREE weekly newsletter exclusively covering the latest updates from the real estate crowdfunding world
What is Mezzanine Debt?
In commercial real estate, traditional bank financing is typically utilized as the primary source of capital. The bank holds the first mortgage position, and as such, this loan falls at the bottom of the capital stack. Most borrowers will seek upwards of a 75% loan-to-value ratio for their deals, though not all are able to secure this level of leverage for one reason or another. This is where mezzanine debt comes into play.
Mezzanine debt is a bank or private money loan that is subordinate to senior debt financing. It holds the second position in the capital stack, after all other recorded debt but ahead of all equity positions. The rates for mezzanine debt can often be two or three times as high as traditional bank debt, in most cases no principal amortization is required, and mezzanine debt takes no part in back-end profit sharing; it is strictly a risk mitigated yield play for investors.
What is Preferred Equity?
Preferred equity is a financing tool that has been around for decades but has only recently emerged in the commercial real estate world. Preferred equity is similar to preferred stock in the corporate world. Preferred equity is subordinate to all debt, but superior to all common equity. Therefore, preferred equity is generally considered to hold roughly the third position in a commercial real estate capital stack.
It is commonly used in three scenarios: (1) a mezzanine loan already exists but the sponsor needs additional equity to complete the project; (2) the senior debt provider does not agree to a mezzanine loan for underwriting purposes; or (3) the sponsor is looking to reduce its own equity in a transaction to increase its liquidity.
Learn more about real estate debt and equity with Gower Crowd today!
Mezzanine Debt vs. Preferred Equity: The Differences
Although mezzanine debt and preferred equity function in similar capacities and are priced around the same targets, there is a key difference between the two: as their names imply, one is debt and the other is equity.
Because mezzanine financing is considered a loan to the project, mezzanine debt providers are considered lenders and have different recovery rights than equity holders.
In terms of rates, mezzanine debt and preferred equity are roughly the same. Mezzanine financing will sometimes have marginally better returns. An existing building might be priced around 8-12% whereas a development deal, given its higher risk profile, would be priced closer to 10-13%. Preferred equity is priced slightly higher, usually around 1% more than one might expect to get with mezzanine debt. The points charged by either the mezzanine or preferred equity will typically offset any of these marginal differences in rates.
Another difference between mezzanine debt and preferred equity is related to how cash flow is distributed. Let’s say both pay a 13% interest rate. Typically, a mezzanine loan will require payment of 8% and accrual of 5% with no cash distributed until the sponsor meets at least the 8% threshold. Preferred equity investors are more likely to structure a deal in which the full 13% must be paid before any cash flow is distributed to the sponsor or common equity investors for any reason.
Another key difference is that mezzanine debt functions more traditionally as senior debt might, with foreclosure rights over the real estate which it holds as collateral for the loan it is providing. Preferred equity, however, retains rights, in the event of borrower default, to take over the entity that owns the real estate, not the real estate itself. This is an important distinction. By having the right to remove the developer/sponsor from the operating entity rather, the preferred equity holder is not seen by senior secured lenders as being a lender at all; hence the epithet ‘equity.’ However, preferred equity holders only receive interest and like lenders share in none of the back-end profits.
This function emerged after the Global Financial Crisis of 2008-09 when lenders increasingly restricted borrowers from placing second tier debt in the capital stack. To ameliorate this inconvenience, preferred equity morphed into being what it is today; a way for borrowers to increase leverage, without taking on more debt.
Structure
Mezzanine Debt
Mezzanine debt can be structured in a few different ways.
Occasionally, there is a second mortgage recorded against the property itself as collateral. This structure must be approved by the senior lien holder (i.e., the bank) which is why this structure is so rarely used.
The second way to structure mezzanine debt is to have a senior lender come in and do what’s called an “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 whereby the senior debt is priced differently than the mezzanine debt, but the borrower pays a blended rate across the loan – usually somewhere around 7% or 8% over LIBOR.
The third (and most common) way to structure mezzanine debt is to have it take a subordinate position to the senior loan. Rather than recording a lien against the property, the borrower creates a “parent of the borrower” entity that actually owns the LLC doing the deal. The mezzanine debt provider is then assigned securities in the parent of the borrower entity, which are effectively membership interests in the LLC, despite this otherwise being a loan. Therefore, in the event of foreclosure, the mezzanine debt provider Is actually forcing the sale of those securities through a UCC-1 as opposed to a traditional mortgage foreclosure – a much easier, faster and less costly process.
Determining which of these mezzanine debt structures to use is often driven by the willingness of the senior lender to allow for mezzanine debt, in general, and then under what conditions.
Preferred Equity
Preferred equity, as the name implies, is a form of equity. It is not a loan. Preferred equity 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 default. This ownership stake is calculated based on how much the preferred equity investor contributes relative to overall equity in the project.
The agreement used to structure these deals, known as a recognition agreement, is generally negotiated only between the preferred equity investor and common equity partner. The senior debt provider usually has less control over these negotiations, except where the loan documents stipulate that the lender has the right to review and approve any preferred equity transactions. Otherwise, the role of the senior (or mezzanine) debt provider is limited as preferred equity is subordinate to all debt financing.
Foreclosure
Mezzanine Debt
In the event of foreclosure, the mezzanine lender will be forced to sell the securities of the parent company via the Article 9 UCC foreclosure process. As such, mezzanine lenders have the benefit of a streamlined, statutory process that can help remove a defaulting sponsor. Through the UCC process, foreclosure on the securities of an LLC can generally be accomplished in 45 to 60 days. Upon consummation of the foreclosure, the mezzanine lender will own 100% of the LLC that owns the property and will have effectively removed the sponsor from the structure.
Historically, senior lenders would not allow mezzanine debt providers to take any action until there was an actual bankruptcy. That is beginning to change. Over the last few years, per regulations enacted as a result of the Great Recession, most banks are now required to notify the mezzanine investor prior to default so that the mezzanine lender has an opportunity to work out an arrangement that would help the borrower avoid default.
Preferred Equity
If a sponsor is in default, preferred equity (like mezzanine lenders) do 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 secured a mortgage to the property using the real estate as collateral.
Instead, the primary remedy available to the preferred equity investor is to effectively dilute the developer’s common equity shares down to zero and then take over management of the venture. In less extreme scenarios, the developer may remain in the joint venture, though they’d take on a passive role as a limited partner with limited rights and authority.
Restrictions on Senior Debt
Mezzanine Debt
Mezzanine debt functions much differently than senior debt. Senior debt is a loan from a bank. The bank will have made that loan based off the asset’s value, and as such, uses that asset as collateral for securing the loan. Conversely, mezzanine debt is not collateralized by assets. Instead, mezzanine loans are made against the cash flow of an asset or business.
The biggest hurdle for sponsors to overcome when seeking mezzanine debt is their senior lender’s approval. An intercreditor agreement is negotiated between the senior lender and mezzanine lender, and that agreement outlines the mezzanine lender’s rights and cures in the event of default. The senior lender generally has the upper hand in these negotiations and will generally prohibit a range of cures to protect its own position.
Preferred Equity
As noted above, there is less of a relationship between preferred equity and the senior lender. This is because preferred equity is subordinate to all debt. That said, the senior debt provider might require certain conditions to be met. For example, the lender might require any equity transfer above a certain threshold to be subject to a customary “know-your-client” review. The bank may require any transferee to meet certain net worth and liquidity requirements. The senior debt provider may even require the original preferred equity investor to retain ownership of a certain percentage of the investment. In the event of default, whereby the preferred equity investor removes the developer as manager, the preferred equity investor may be obligated to submit quarterly reports that provide detailed financial statements.
Get access to our FREE weekly newsletter exclusively covering the latest updates from the real estate crowdfunding world
Tax Treatment
Mezzanine Debt
The tax treatment of mezzanine debt is typically more straightforward than that for preferred equity. The sponsor will generally deduct interest as an expense, which the mezzanine lender will then claim as ordinary income. The fact that interest is tax-deductible is one of the reasons borrowers prefer mezzanine debt to preferred equity.
Preferred Equity
The tax treatment of preferred equity is more complicated than that of mezzanine debt. How it is taxed will depend on how the deal is structured. For example, the operating agreement may provide that the preferred equity investor’s interest is to be treated as debt for tax purposes. In such case, the sponsor would take interest deductions for payments to the preferred equity investor but could also then be liable for cancellation of indebtedness if the preferred equity investor is not paid in full (a process known as “recharacterization”). Other deals may be structured to treat preferred equity more like true equity, which changes the tax implications.
Moreover, tax treatment will depend largely on how the distributions are characterized and the more specific tax attributes of the investor.
Gower Crowd can help you understand the concept of preferred equity and mezzanine debt
Which is Right For You?
There are certainly benefits to utilizing either mezzanine debt or preferred equity. Mezzanine debt will likely appeal to anyone struggling to raise equity; it allows the sponsor to close the gap between the senior lender and common equity. The biggest downside to mezzanine financing is that it’s still leverage. Sophisticated borrowers are usually cautious about becoming over-levered. With more debt, the risk of foreclosure increases.
Preferred equity presents an increasingly viable alternative. Most lenders require at least 15% of capital in a transaction to be equity. Very few banks will treat mezzanine financing as equity, whereas almost all will accept preferred equity as same. Preferred equity is also a great way for sponsors to increase their liquidity (in lieu of selling an asset) or grow their portfolios. This also allows sponsors to retain all upside after serving a preferred return.
These considerations notwithstanding, it is really the nature of the deal – including the requirements imposed by the senior lender – that will largely dictate which of these financing tools is most appropriate for you.
Newbie
If you want to build your wealth and earn passive income from real estate investing and are looking at deals on marketplace platforms or through developers online, then I recommend you start by the 8 Key Financial terms so you can understand every deal you look at.
The 8 Financial Keys are not only a great way to get started, they are also essential to understanding how you’ll make money in any real estate deal.
You’ll learn the most important financial concepts you need to know in real estate investing that apply to every type of real estate no matter the asset class (office, industrial, residential, hospitality, retail).
Intermediate Investor
If you’ve got some online real estate investments under your belt already and are beginning to receive passive income checks each month, or have been paid off with profit – or (hopefully not) are finding that some deals are not quite panning out the way you expected, then check out this page for a wealth of free resources.
Here I cover everything from beginner all the way to very advanced real estate concepts.
You’ll find podcasts with developers, researchers, professors and other industry experts, detailed articles, and lots of videos, both short and long that are all easily searchable and totally free.
Advanced Investors
I am not shy about being straightforward about real estate investing; it is exciting, lucrative, and can help you build wealth and income as part of your investment portfolio, but it is not without its risks.
As an advanced investor you know this already, so I’ve put together a webinar for you that guides you through one of the most important components of real estate investing: Real Estate Contracts – reading between the lines.
This is advanced learning and based off conversations I had with three of the top real estate attorneys in the country, combined with my own personal experience. Access it here; it could be the most important webcast you watch all year.
Website Disclaimer: All Content contained on this website is intended for informational purposes only and does not purport to be complete or accurate. No recommendations are made or intended to be made regarding investment in real estate of any kind. For further information on any investment opportunity contained in any content of this website, you should visit the respective crowdfunding portal or site where such investment opportunity is published. None of the content presented on this website has been prepared with any reference to any particular user’s investment requirements or financial situation, and you are encouraged to consult with professional tax, legal and financial advisors before making any investment decisions or including the decision to invest at all. GowerCrowd makes no representations or warranties as to the accuracy of any information and accepts no liability or fiduciary responsibility whatsoever. Offers to sell, or the solicitations of offers to buy, any security can only be made through official offering documents through registered portals outside of this website. Investors should conduct their own due diligence, not rely on the financial assumptions or estimates displayed on this website, and are encouraged to consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks associated with any investment opportunity. Neither Adam Gower nor GowerCrowd or any related entities are a registered broker-dealer, funding portal, or investment advisor and does not conduct any activity that would require any registration as such.