When it comes to financing commercial real estate, no one can go to a bank and get the whole bill covered. No matter how great your credit is, there’s no bank out there that will fully finance anything — period. There always has to be some downpayment and collateral.
But if you’re an experienced investor or enter into a joint venture with one, banks will often finance up to 75% LTV of the property in the form of senior debt. Senior debt, also known as a mortgage, means that it has priority in repayment and has the lowest interest associated with it compared to other forms of debt.
Commercial real estate investors have many options to cover the remaining 25-20% of the project. In the battle between preferred equity vs common equity, developers usually like to rely on preferred equity and mezzanine debt as much as possible. That’s because common equity, although the riskiest investment, is also tied to the highest rates (some upwards of 20%) and shares in back-end profits.
What’s the Difference Between Preferred Equity vs. Mezzanine Debt?
As the names imply, the primary difference between mezzanine debt and preferred equity is that one acts as debt, and the other acts as equity. Both types of financing are hybrid in the sense that they both enjoy some characteristics of debt and equity in the ways they are structured, which we’ll discuss later. But mezzanine financing, whether from an institution or private lender, is viewed as debt. That’s because it’s next in line to be repaid after senior debt, and the recall rights are structured differently than preferred equity.
Benefits of Mezzanine Debt and Preferred Equity
While the two have their differences, from the buyer’s viewpoint, mezzanine debt and preferred equity have some similar benefits.
As we mentioned earlier, mezzanine debt and preferred equity are much less costly than issuing common equity, which has rates as high as 20%. While not as affordable as senior debt from a bank, both preferred equity and mezzanine loans hold a rate of return between 10-15% on average. However, these rates can go up or down depending on the terms.
If a developer is getting close to the closing date and still hasn’t secured financing, mezzanine debt and preferred equity are both excellent means to quickly close the gap. Relying on common equity to do the job is time-consuming, and there’s never a guarantee that investors will secure all the funding they need.
We’ll dive deeper into how the IRS treats mezzanine loans and preferred equity a bit later. But both forms of CRE financing can enjoy tax benefits depending on how the deal is structured.
How Can Mezzanine Debt Be Structured?
As mentioned, the primary difference between mezz debt and PE is how they are structured. Mezzanine comes from Latin meaning “middle”. It lies right below senior debt in the capital stack but above equity, meaning it’s the next to receive payment after the bank is paid in full.
Although it’s considered debt and lies below senior debt on the capital stack, mezzanine debt functions quite differently. Bank financing uses the value of real estate assets as collateral. On the other hand, mezz debt is backed by the business’s cash flows. Because of this, senior lenders get some say in how mezzanine financing is structured, even if it’s coming from another bank or private firm.
Most senior lenders will require an inter-creditor agreement between themselves and the mezzanine lender. Even if the mezzanine lender is a bank, they are seen as a junior lender in the deal’s structure. Inter-creditor agreements can be significant hurdles for buyers since senior lenders can put strict terms within them to protect their investment.
Another unusual aspect of mezzanine debt’s structure is that there are often embedded options that can convert the debt into equity, given that particular conditions are met. Because of this, mezzanine debt does possess similar features of preferred equity and is favorable to lenders.
How Is Preferred Equity Structured?
Preferred equity is subordinate to all debt. Because of this, preferred equity deals are much more flexible compared to senior or mezzanine debt. However, depending on senior debt terms, sometimes preferred equity investors must be approved by senior lenders.
Preferred equity lies under mezzanine debt in the capital structure and is usually slightly more costly. Preferred equity rates typically have a set rate of return, and the investment typically has a predetermined exit date.
Because it is equity and not debt, PE investors have ownership rights in the property and get special privileges compared to common equity. Preferred equity investors get voting rights on major company decisions on top of their dividends.
Preferred Equity vs. Mezzanine Debt in the Event of a Foreclosure
In the unfortunate event of a CRE foreclosure, preferred equity investors and mezzanine debt lenders have different ownership rights. They both can become indebted to senior lenders if foreclosure occurs before the senior debt is paid off. But they’re both in a position to recoup their investments over time. Let’s first cover mezz debt.
Mezzanine Debt During Foreclosure
What a mezz lender is entitled to do during default depends on when it occurs. If the senior debt is not totally repaid, the mezzanine lender will have to adhere to the terms of the intercreditor agreement with the senior lenders. Typically during this time, senior lenders will take control of the asset, and mezzanine lenders will take control of the business entity or LLC.
If the senior debt is repaid and default occurs before the mezz debt is paid off, mezzanine lenders can issue a foreclosure themselves and gain control of both the assets and LLC. However, mezzanine lender foreclosure resolutions vary greatly depending on whether or not equity call options have been exercised before the default.
Preferred Equity During Foreclosure
Foreclosure for preferred equity investors looks a little different. Since they own part of the company, preferred equity investors can never foreclose on a property as lenders can. However, prudent PE investors often exercise their right to take control of a developer’s (general partner) ownership rights forcing them out of the company, gaining primary decision rights.
With luck, preferred equity investors can do this before the CRE property is foreclosed upon and correct the company’s course, or sell it all together—repaying all outstanding debt. However, if foreclosure is imminent, there are often default clauses written into preferred equity contracts with developers where some, if not all, their initial investment is recouped. Still, in some instances, PE investors simply lose their money, which is why preferred equity investments are often viewed as risky.
Taxes: How Does the IRS Treat Mezzanine Debt vs. Preferred Equity?
As we mentioned before, there are some tax advantages for buyers when utilizing mezzanine debt and preferred equity. Developers like to use mezzanine debt because they can write off the interest paid in their end-of-year tax returns since lenders claim it as ordinary income.
Writing off payments with preferred equity is possible, but it’s a little more complicated. The structure of the preferred equity deal will determine if tax write-offs are available. For a general partner to write off interest, the limited partner must agree to claim the interest as debt, not income.
Which is Best to Close the Investment Gap?
Choosing to use mezzanine debt, preferred equity, or both to secure funding for a CRE deal is different for everyone. In many cases, wanting to close a deal fast is a big reason why developers turn to either form. They are also less costly than common equity and have some appealing tax advantages.
The crucial thing to consider is the level of control you’re willing to sacrifice in your project. If you have done business with some preferred equity groups in the past and have a good relationship, that might be the way to go. However, if you’re new to commercial real estate financing and want to maintain control over the decision-making process, mezzanine debt might be the right choice for you.