Categories: Education

Should You Choose Preferred Equity
or Mezzanine Debt for Real Estate?

Introduction

Both preferred equity and mezzanine debt are part of the commercial real estate capital stack. While both investments can provide risk-adjusted returns to investors, they do it in different ways.

In this article, we will discuss the difference between preferred equity and mezzanine debt for real estate, how each is structured, and how real estate sponsors use both types of investments to generate returns in a private equity real estate investment.

Related: Real Estate Funds vs. REITs

What is Preferred Equity?

Preferred equity is part of the real estate capital stack, along with common equity, mezzanine debt, and senior debt. Preferred equity in real estate is an equity investment in a joint venture that directly or indirectly develops, owns, and operates a private equity real estate project.

Preferred equity investments have some similarities to mezzanine debt, which we will discuss in the second part of this article. However, preferred equity is not a loan and is generally unsecured by the real property.

The position of preferred equity in the capital stack places the holder of preferred equity in front of over common equity investors for repayment from the property’s cash flow or profits, but behind a senior lender with a first or second position mortgage.

A preferred equity holder receives priority distributions after the debt has been serviced, usually with a fixed rate of return over a specified period of time.

These distributions can have a regular payment schedule or be structured to accrue. Preferred equity normally includes an “equity kicker,” which is an entitlement to additional profits if the project performs better than anticipated.Notwithstanding a preferred equity holder’s subordinated position to debt holders, preferred equity is normally entitled to force the sale of the property in the event of non-payment. Additionally, in the event of default, a preferred equity holder may also remove the general partner from the joint venture and take control of the management of the project going forward.

Features of Preferred Equity

Typical features of a preferred equity investment include:

  • Preferred equity investors and the developer or general partner are joint venture partners.
  • The general partner is responsible for the day-to-day activities of the investment, with the preferred equity investor having final approval on major decisions.
  • Preferred equity investor receives regular repayments based on an agreed-upon schedule or structured to accrue.
  • A preferred equity investor may remove the general partner from the control of the joint venture in the event of the general partner’s default.
  • The general partner may be asked to provide the preferred equity investor with a “bad boy” guarantee which provides for personal liability against the general partner.
  • Preferred equity investments normally have a mandatory redemption date that coincides with the maturity date of any mortgage loans.

The structure of preferred equity can be “hard” with more debt-like characteristics, or “soft” with more equity-like characteristics, or a combination of both.

When is Preferred Equity Used?

For the passive real estate investor, preferred equity can be a safer way to invest in a private equity real estate deal when compared to common equity due to the seniority in receiving distributions from the project.

Preferred equity is often thought of as having a hybrid risk/return profile similar to senior debt, but with a share of any upside when the project is sold. Preferred equity usually provides a fixed rate of return over a specified period of time, along with an upside when the property performs better than expected.

Even if the project does not have positive cash flow, the private equity investor may still receive regular income. Because payment to preferred equity holders is prioritized, investing with preferred equity can be attractive through all stages of the real estate market cycle. Although preferred equity investments are generally not secured by the real property, they can provide for the transfer of control and management rights should the general partner default. This allows the preferred equity investor to take control of the project – or assign management to a third party – to cure the default and keep the project on track.

For the real estate developer, sponsor, or general partner, preferred equity can be a good source of capital for large projects that require more funds than what a traditional lender is willing to provide. Rather than borrowing additional money in the form of second or third-position loans, a developer will offer preferred equity to real estate investors.

Developers and sponsors of private equity real estate investments with a proven track record of success may also offer an investor “hard” preferred equity.

In this context, hard preferred equity means the sponsor pledges its own equity in the joint venture to the private equity investor. Should the sponsor default, the preferred equity investor has the right to foreclose on the sponsor and remove it from the project’s ownership structure.

Preferred Equity Structure

To better understand how preferred equity works, we will use an example of a private equity real estate project for a multifamily property.

The general partner is the sponsor of the private equity deal and is purchasing a core plus apartment property. Core plus investments can offer slightly higher returns than core properties while still being suitable for investors seeking to minimize risk and preserve capital.

The general partner is the sponsor of the private equity deal
and is purchasing a core plus apartment property.

The property has a $3 million purchase price and requires $250,000 in additional capital for improvements and installation of state-of-the-art Class A technology to stabilize the tenant base and increase the rental income.

The sponsor is acquiring the property with a 50% down payment and investing $300,000 of its own money. Preferred equity investors are offered a fixed rate of return of 9% after the senior debt holder has been paid, plus a 20% share of any appreciation gained as an “equity kicker” when the multifamily property is sold or refinanced.

SourceAmountPriorityBenefits
Sponsor$300,000LastRemaining cash flow and appreciation.
Preferred Equity$1,200,000SecondFixed 9% return + 20% equity kicker
Senior Debt$1,500,000FirstEarns a fixed interest rate of 4%.

During the initial holding period of five years, the lender has received monthly mortgage payments of principal repayment and 4% interest payments. After the debt has been serviced, the preferred equity investor has received a fixed 7% return, while the sponsor has received its share of the remaining cash flow.

After five years, the property is appraised for $4 million, and the existing loan is paid off. The preferred equity investor receives its initial investment of $1.2 million plus $200,000, which is its 10% share of the property appreciation, while the sponsor receives any remaining profits.

Related: Investing in Real Estate Properties: The Ultimate Guide

What is Mezzanine Debt?

Mezzanine debt is another part of the capital stack located midway between senior debt and preferred equity.

Mezzanine debt acts as a bridge or floor between the senior debt on the ground floor of the capital stack and the preferred and common equity above. Because of its location in the capital stack, mezzanine debt is subordinate to senior debt but has priority over preferred equity and common equity.

As an alternative to investing in the equity side of a real estate joint venture, investors can also loan money as mezzanine debt to the developer or sponsor. Generally speaking, mezzanine debt has a higher rate of return than senior bank debt in exchange for being subordinate to the senior debt.

Mezzanine debt may offer stronger risk-adjusted returns from the downside protection due to its position in the capital stack. However, upside potential is also typically limited, unlike preferred equity which offers investors an uncapped upside potential albeit with a higher level of risk.

A mezzanine debt holder receives interest payments after the senior debt has been serviced but before payments are made to preferred equity holders. Mezzanine debt typically pays a return slightly higher than the interest on senior debt, but less than the rate of return on a preferred equity investment.

While mezzanine debt can offer risk-adjusted returns, there are still potential risk factors to consider with mezzanine debt. Investors should research the experience of the borrower or sponsor, its creditworthiness, the market value of the project, and market demand for the asset.

In addition, investors in mezzanine debt should also analyze the total leverage used in the project by paying attention to the loan-to-value (LTV) and debt service coverage ratio (DSCR).

Features of Mezzanine Debt

Typical features of a mezzanine debt investment include:

  • Subordinate to senior debt with priority over preferred equity and common equity.
  • Higher interest rate than senior debt but lower rate of return than preferred equity.
  • Generally, it is not secured by the real property.
  • The term of a mezzanine debt loan can be shorter than senior secured debt.
  • Payments can be interest-only rather than repayment amortized over the term of the loan.

How is Mezzanine Debt Structured?

Mezzanine debt in a private equity real estate project can benefit investors by offering stronger risk-adjusted returns while providing the sponsor with alternative forms of financing.

For the investor-lender, mezzanine debt can provide the opportunity to earn a higher rate of interest on the loan provided to the sponsor of a private real estate equity investment. In many instances, mezzanine debt can generate equity-like returns with minimal bond-like risk.

While investing in mezzanine debt is not entirely risk-free, there is a lower risk of loss because mezzanine debt takes repayment priority over preferred equity and common equity. The trade-off is that there is not the same potential return upside compared to investing in equity.

For the sponsor-borrower, mezzanine debt reduces the amount of equity needed to acquire a property.

Sometimes the borrower does not have access to enough equity and opts for mezzanine financing. Other times, a sponsor may choose to use mezzanine debt to avoid equity dilution. While mezzanine debt normally carries a higher interest rate than senior debt, that cost is usually below the cost of equity in a well-planned real estate development project.

Mezzanine debt can also be used to boost potential cash on cash returns to equity investors. For example, assume a $3 million multifamily property generates an annual NOI (before debt service) of $240,000.

The sponsor has two options.

It can use a capital stack consisting of $1.8 million in senior debt and $1.2 million in equity for a net cash flow of $105,000. Or, the sponsor can choose a capital stack of $1.8 million each in senior debt, $450,000 in mezzanine debt, and $750,000 in equity for a net cash flow of $75,000.

  • No mezzanine debt: $105,000 net cash flow / $1.2 million equity = 8.75%

  • Mezzanine debt: $75,000 net cash flow / $750,000 equity = 10%

For the sponsor-borrower, mezzanine debt reduces
the amount of equity needed to acquire a property.

Mezzanine debt structure

Now let’s take a look at the capital stack structure we used in the previous preferred equity example, but with the addition of mezzanine debt:

Source AmountPriorityBenefits
Sponsor$200,000LastRemaining cash flow and appreciation.
Preferred Equity$550,000ThirdFixed 9% return + 20% equity kicker.
Mezzanine Debt$450,000SecondEarnest a fixed interest rate of 7%
Senior Debt$1,800,000FirstEarns a fixed interest rate of 4%.

Note from the above example that potential returns are commensurate with the level of risk. Because senior debt takes priority over all other forms of financing, the return is lower. As the level of potential risk increases up the capital stack, so does the amount of potential reward.

What are the Differences?

While both preferred equity and mezzanine debt are used as part of the capital stack used to acquire and develop a private equity real estate investment, there are some key differences between the two sources of funds:

  • Mezzanine debt is a loan to the project and has different recovery rights than a preferred equity investment.
  • Rates on preferred equity may be slightly higher than mezzanine debt to compensate the investor for potential increased risk.
  • Cash flow is distributed first to the mezzanine debt holder and secondly to the preferred equity investor.
  • 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.

Related: What You Need to Know About Multifamily Real Estate Investing

Effects of Foreclosure

The effects of foreclosure vary based on the investor’s position in the capital stack. 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.

Preferred Equity

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

In some cases, the preferred equity holder may also be able to receive the sponsor’s share of equity in the project should the sponsor default.

Mezzanine Debt

In the majority of private equity real estate investments, the senior lender and mezzanine debt holder sign an inter-creditor agreement when financing on the project closes. If the sponsor defaults, the inter-creditor agreement proactively addresses the rights of the senior lender and mezzanine debt holder.

Generally, the mezzanine investor will be given the opportunity to work with the sponsor to cure or may be given the opportunity to buy the defaulted senior mortgage at a price equal to the outstanding senior debt.

Conclusion

Investors should weigh the benefits and potential risks of investing in either preferred equity or mezzanine debt. For private real estate equity investors seeking the lowest level of risk, mezzanine debt can provide consistent bond-like returns.

Those willing to accept a slightly higher level of risk in exchange for greater rewards may choose to invest in preferred equity. In both cases, it is important to analyze in detail the offering memorandum and work with a sponsor who has a history of building wealth for its investment partners.

Related: Snowball Debt Strategy in Real Estate Investing

Do you want to learn more about how Smartland invests? Contact us today and see if a real estate investing strategy is the right choice for you!


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