Mezzanine debt and preferred equity both sit between the senior debt and common equity in the capital stack and generally serve similar functions to fill a gap in funding and/or provide additional leverage.

capital stack

The primary difference between the two is that mezzanine debt is generally structured as a loan that is secured by a lien on the property while preferred equity, on the other hand, is an equity investment in the property-owning entity.

Benefits of Mezzanine Debt and Preferred Equity

Both Mezzanine debt and preferred equity can be effective tools to provide a borrower or sponsor with higher levels of leverage at a lower cost than common equity. In return, investors get a more secured position relative to the equity but a higher yield for their additional risk in being subordinate to the senior loan.





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What's in a Name: Mezzanine Debt Versus Preferred Equity


J. Dean Heller


Seyfarth Shaw lLP
May 24, 2012

18 Stanford J. Law, Business and Finance 40 (Fall 2012).


Abstract:     

Mezzanine loans and preferred equity interests are both forms of investment in commercial properties; they are favored by investors, particularly institutional investors, that want a fixed, or at least floored, return and priority as to both their return on and return of investment. In its most common form, a mezzanine loan is secured by the investment property, but only indirectly, by a pledge of the equity in the entity (usually a limited liability company or limited partnership) that owns the property. Preferred equity, on the other hand, usually takes the form of a direct equity investment in the property owner, with a fixed, preferential return that is paid prior to distributions to the “common” equity interests in the owner. Apart from this difference, mezzanine debt and preferred equity can -- and often do -- have similar terms and conditions; nonetheless, institutional and other real estate investors appear generally to regard mezzanine debt as an intrinsically better form of investment than preferred equity. The article postulates that capital markets may be giving undue deference to the notion that one is “debt” and the other is “equity” and analyzes each of the presumed legal advantages of mezzanine loans over preferred equity interests. While acknowledging that for certain type of investors and certain types of properties, mezzanine debt may be the preferable form of investment, the article concludes that, overall, preferred equity provides an investment structure that works as well as -- and in some cases better than -- mezzanine debt.

Published verison of paper varies slightly from SSRN version.

Number of Pages in PDF File: 28

Keywords: preferred equity, mezzanine loans, real estate investment

JEL Classification: K11, K12



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Need for Mezzanine Loans and Preferred Equity

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Equity or Value Gap: Over leveraged properties to be refinanced

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Prohibitions And Restrictions: CMBS and other mortgage lender prohibitions on junior mortgages

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Sponsor Desire for Greater Leverage: Acquiring the asset with minimum of equity or cash out 13



Preferred Equity Structures- 

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Preferred Equity Structures- 1

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Term Preferred Equity covers a lot of ground. Sometimes it refers to what is effectively a Mezzanine Loan equivalent. Other times it refers to a equity with a stated preferred return but that is in all other ways the same as common equity.

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One way to think about preferred equity structures is as a continuum with debt like preferred equity on the one end and common equity like preferred equity on the other 16



Preferred Equity Structures- 2

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Debt Equivalent. Looks and acts a lot like a mezzanine loan:

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A) Fixed Monthly Distributions – To be paid regardless of cash flow B)

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B) Fixed, Mandatory Redemption Date

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C) Carve-out Guaranty and Environmental Indemnity

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D) Preferred Equity Investor has removal right (including for failure of timely distributions)

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E) Major decisions requiring Preferred Equity Investor vote mimic Mezzanine Loan covenants

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F) Removal results in loss of all management rights by sponsor (may (though atypical) result in forfeiture of sponsor’s interest)

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G) Failure of timely distribution or other default results in default preferred equity rate (20+% not atypical)

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H) Generally no share in residual

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I) Generally no share of losses (outside of reversal of prior allocated income)

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J) Preferred Investor has no obligation to contribute additional capital

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K) Preferred Investor may be entitled to early redemption premium 17




“True” Equity. May have any number of different features:

A) Often a stated preferred return, paid first but only out of cash flow/available capital proceeds (sponsor may have similar stated return which may be subordinate or even pari passu)

B) After stated return, cash flow/capital event proceeds allocated based upon percentage interests. Preferred Investor shares in the residual. Typically sponsor receives a promote

C) Promote may be paid before all capital returned (but after stated return paid) or only after all capital returned and stated return paid. Guaranteed return of promote if Preferred Investor does not receive stated return

D) Preferred Equity Investor participates in losses

E) Major decisions may be longer or shorter list. Budget approval

F) Removal right for “bad acts” may also be performance standard based. Removal leads to loss of management rights of sponsor (but not forfeiture). Sponsor may retain consent rights over certain major decisions (e.g., sale of the Property). Sponsor needs to protect against self dealing transactions.

G) Deadlocks – (i) one member has tie-breaker vote; (ii) buy-sell provision; (iii) maintenance of status quo

H) Preferred Equity Investor put or forced sale right after stated period 18

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Reason to Treat Preferred Stock As Debt Rather Than Equity

The main reason to treat preferred stock as debt rather than equity is that it acts more like a bond than a stock, and investors buy it for current income, not capital appreciation. Like common stock, preferred stock represents an equity stake in a company, but its many features make it more like a debt security.

Limited Upside Potential

Both preferred stocks and bonds have limited upside potential. Bonds have maturity dates when the principal is repaid in full. The closer a bond gets to maturity, the closer it trades to its face value, or the amount to be repaid at maturity. Preferred stocks have call provisions, which is the ability of the issuer to call, or redeem, them at a predetermined value after a certain date. As a preferred stock gets closer to the call date, investors become reluctant to pay more for it than what it can be called for.

Fixed Income

Both preferred stock dividends and bond interest are typically fixed for the life of the security. Dividend yields on preferred stocks are usually similar to interest yields on comparable bonds. Investors buy bonds and preferred stocks for current income.

Interest Rate Sensitivity

Both preferred stocks and bonds are interest rate sensitive: When interest rates go up, both go down in price, and vice versa.

Safety of Principal

Preferred stocks and bonds are considered safer than common stocks. If a company goes into bankruptcy liquidation, its assets are sold to pay off the investors. Bondholders are paid ahead of stockholders, but preferred stockholders are paid ahead of common stockholders. The safety of both bonds and preferred stock depends on the issuer’s credit rating. Credit rating reflects a company’s ability to pay its obligations, be it bond interest or preferred stock dividends. When an issuer’s credit rating is changed, it affects the price of both its bonds and preferred stocks.

Preferred Stock Vs. Bond Risk

Preferred stocks are riskier than bonds. If a company misses a bond interest payment, the bondholders can force it into bankruptcy to get their money back, but the company can cut or suspend dividends on preferred stock at any time with no recourse for investors. When a bond matures, it must be paid off in full, but a preferred stock call date is a right, not an obligation -- a company can choose not to call a preferred stock if it is to its advantage. For example, when interest rates are high, a company has no reason to call a low-yielding preferred stock if it then has to borrow at higher rates.