Structure and security
Mezzanine debt is structured as a loan secured by a pledge of the equity interests in the property-owning entity. If the borrower defaults, the mezzanine lender can foreclose on the equity interests and take control of the property-owning entity, without disturbing the senior mortgage. This is the key reason senior lenders generally accept mezzanine over a second mortgage.
Preferred equity is structured as an equity investment in the property-owning entity, with a preferred return that must be paid before any distribution to common equity. There is no security interest, and remedies on default are typically a forced sale or the right to remove the common-equity sponsor as managing member.
Returns and how they're paid
Mezzanine debt is typically priced at a fixed coupon (12%-18% all-in is common in current markets), with current pay funded from cash flow and accrual funded if cash flow is insufficient. There is usually no equity participation.
Preferred equity is typically priced with a preferred return (8%-12%) and an equity participation (an additional 4%-8% IRR on top of the pref). The combined target return is often similar to mezzanine debt, but the cash-pay component is usually lower, which is why preferred equity often works better during a heavy renovation or lease-up.
When to use which
Mezzanine debt typically wins when the senior lender allows it (most agency and CMBS loans do, with intercreditor mechanics), when current pay is supportable from in-place cash flow, and when the sponsor wants to preserve maximum equity upside.
Preferred equity typically wins when the senior lender prohibits mezzanine (many construction loans), when cash flow during the business plan is too thin to support current pay, or when the sponsor needs more flexibility on the timing and structure of the pref payment.
Frequently asked questions
- What's the cost difference between mezzanine debt and preferred equity?
- All-in cost of capital is typically similar (12%-18% IRR), but the structure differs. Mezzanine debt typically requires current pay from cash flow. Preferred equity often allows more accrual, with a portion of the return paid only at exit through equity participation.
- Can mezzanine debt be used with agency multifamily loans?
- Yes. Fannie Mae and Freddie Mac both permit mezzanine debt subject to intercreditor mechanics and combined LTV / DSCR tests. The combined senior + mezz LTV typically can't exceed 80%-85%.
- Does preferred equity dilute common equity ownership?
- Preferred equity is typically structured as a separate class of equity with a preferred return and equity participation, rather than as a percentage of common equity. The dilutive effect depends on the equity participation negotiated, but it's usually less dilutive than raising additional common equity at the same target return.
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