Mezzanine Debt vs Preferred Equity: Understanding key differences that exist in your commercial real estate investment.
Mezzanine debt and preferred equity are two close relatives in the world of commercial real estate investment options that offer some similarities along with some distinct differences.
The differences that exist between preferred equity and mezzanine investments appear fairly straight forward. After all, mezzanine is a form of debt, while preferred equity sits on the equity side of the ledger when it comes to financing a development, redevelopment or acquisition. What often creates confusion for investors is that both are forms of “gap” funding that allow a sponsor to fill the missing middle that exists between a senior loan and the equity or down payment on that loan.
The four most common types of investment in a commercial or multifamily real estate deal are the primary loan, a secondary mezzanine loan, preferred equity and common equity. Importantly, mezzanine debt has seniority over preferred equity, meaning at the time of a sale or refinance of a property, mezzanine gets paid ahead of preferred equity investors. Effectively, that means greater risk for preferred equity investors. For example, if there are insufficient funds to fully repay all capital, losses are incurred from the top down of the capital stack, meaning that preferred equity would be first to absorb losses. Some other notable differences between mezzanine and preferred equity include:
Secured vs unsecured: A mezzanine loan is secured by the underlying asset. That means that the mezzanine investor/lender has the ability to file a recorded lien against the underlying asset. Preferred equity is an unsecured investment and has no such ability to secure a lien.
Fixed vs variable returns: Mezzanine is typically structured with fixed loan payments on a regular basis, and in some cases also include a final balloon payment. Preferred equity returns are variable in that they are tied to property performance, such as dividends from ongoing net operating income and cash flow.
Ownership stake: One of the incentives for preferred equity investments is that investors receive an ownership stake in the property and a pro rata share in any upside appreciation. For example, if a developer builds an apartment building and sells it for cost, preferred equity investors have no profits, and as such, a return that will be lower than what a mezzanine investor achieved. However, if a developer sells the property for 30, 40 or even 50% more than it cost to build, the preferred equity investors have a stake in those profits. Effectively, preferred equity investors have an opportunity to earn an exponentially larger return. Mezzanine investors have no such ownership stake.
Deal structure: The structure of the deal terms is inherently different. Preferred equity investors may be structured similar to a limited partner arrangement, while mezzanine debt investment is a loan document. Depending on the deal, preferred equity “partners” may have leverage or voting rights and a closer relationship with the sponsor.
Some commercial real estate deals include both mezzanine debt and preferred equity as a means to bridge the financing gap that exists between a senior loan and common equity. Others choose to use preferred equity as an alternative to a mezzanine loan. One reason for that is to avoid negotiating terms between a senior lender and junior mezzanine lender. Such inter-creditor agreements can be complex and time consuming to negotiate, which can create added challenges for a developer or sponsor. For investors, one is not necessarily a “better” option than the other. However, it is important to understand the distinct differences that exist between the two.
As with any investment opportunity, it also is important to conduct careful due diligence and work with a trusted advisor to make sure that the return warrants the risk you are taking with your principal. It also is wise to make sure that an investment is a good match for your tolerance for risk, as well as your investment goals and objectives.
About CanAm Capital Partners
CanAm Capital Partners, LLC (“CACP”) is a New York-based private equity investor, manager and advisor with a primary focus on real estate principal investment. CACP is an affiliate of CanAm Enterprises, the largest EB-5 lender in the United States. CACP and its affiliates have been involved as a principal or lender in transactions with an aggregate transaction value in excess of $3 billion in multiple markets across the U.S. For more information, please visit www.canamcapital.com/cacp.