Mezzanine Debt And Preferred Equity Compared

When a senior lender will not fund the whole cost of a property and the sponsor will not contribute the remainder in cash, the difference is filled by a middle layer. Mezzanine debt and preferred equity are the two usual forms.

Where the layer sits

A capital stack is an order of priority. The senior lender is paid first, the middle layer next, and common equity receives whatever remains after both are satisfied.

The middle layer accepts more risk than the senior lender because it stands behind that lender, and it is compensated with a higher return in exchange for that position.

Both forms occupy the same position economically. The difference is legal, and it determines what the provider can actually do if payments stop.

What mezzanine debt is

Mezzanine debt is a loan, but it is usually secured by a pledge of the ownership interests in the entity that owns the property rather than by the property itself.

That structure exists because the senior lender's mortgage occupies the property, and a second mortgage would generally be prohibited by the senior loan documents.

On default, the mezzanine lender can foreclose on the ownership interests and take control of the entity, which leaves the senior mortgage in place and undisturbed.

What preferred equity is

Preferred equity is an ownership interest with priority over common equity in distributions, not a loan. The provider becomes a member of the ownership entity rather than a creditor of it.

Its return is paid from distributions rather than as contractual debt service, though the documents typically require an accrual that must be satisfied before common equity receives anything.

Remedies are governed by the operating agreement, which commonly allows the preferred holder to take over control of the entity if defined conditions are not met.

Why the distinction matters

Senior lenders care because their documents restrict additional debt, and preferred equity may be permitted where mezzanine debt is not, or may require consent either way.

The distinction also affects bankruptcy treatment, tax characterization of the payments, and the mechanics and speed of enforcement, which differ substantially between the two.

Intercreditor agreements between senior and middle layers set out who may do what, and those documents often matter more than the labels applied to each layer.

The cost of the middle layer

Filling the gap this way is expensive relative to senior debt, and it increases the fixed obligations that must be met before the sponsor sees anything.

These are heavily negotiated structures. An attorney experienced in real estate capital markets and an accountant on the tax treatment are both required, and rules differ by state and over time.