Mezzanine Debt and Preferred Equity

Filling the Gap: When Senior Debt Is Not Enough

A bank will lend 65-75% of a property's value. The deal requires 100% of the purchase price plus closing costs and reserves. The gap between what the bank will provide and what the deal needs is called the equity gap. Filling this gap is where mezzanine debt and preferred equity enter the picture. Both occupy the middle of the capital stack, above senior debt and below common equity. They carry more risk than the first mortgage, less risk than the equity position, and they command returns that reflect that middle ground. For investors, these instruments offer attractive risk-adjusted returns. For deal sponsors, they reduce the amount of common equity required and amplify returns on the equity that remains.

Mezzanine Debt Mechanics

Mezzanine debt (mezz) is a loan, but it is not secured by the property directly. Instead, it is secured by the borrower's ownership interest in the entity that owns the property. If the borrower defaults on the mezz loan, the mezz lender does not foreclose on the property. They take over the borrower's equity interest in the LLC, which gives them indirect control of the asset. This structure exists because senior lenders typically prohibit second mortgages on the property. By lending against the entity rather than the real estate, mezz lenders work around that restriction.

• Rate: 10-15%, reflecting the subordinate position below senior debt
• Security: pledge of borrower's membership interest in the property-owning LLC
• Remedy on default: UCC foreclosure on the ownership interest (faster than real property foreclosure)
• Intercreditor agreement: the mezz lender and senior lender negotiate rights, including standstill periods and cure rights
• Often includes an equity kicker or conversion feature, allowing the mezz lender to convert to equity if the deal outperforms
• Typical term: 2-5 years, coterminous with or shorter than the senior loan

Preferred Equity: Debt That Is Not Debt

Preferred equity sits between debt and common equity. It is technically an equity investment, not a loan. The preferred equity holder owns a percentage of the entity, but their investment carries a preferential return that must be paid before common equity receives any distributions. If the deal generates 8% returns and the preferred equity holder has a 10% pref, common equity gets nothing. The preferred return accumulates (accrues) and must be paid in full before common equity participates. If the deal generates 20%, preferred equity gets their 10% and common equity gets everything above that. Unlike mezz debt, preferred equity does not create a loan on the balance sheet. This matters for loan covenants. Many senior lenders cap the amount of subordinate debt but allow preferred equity because it does not increase the property's leverage ratio from the lender's perspective.

Waterfall on a $5M Deal

Purchase price: $5M. Senior debt: $3.5M (70% LTV) at 5.5%. Preferred equity: $750K with a 10% preferred return. Common equity: $750K from GP and LPs. Year one NOI: $425,000. Debt service on the senior loan: $238,000. Remaining cash flow: $187,000. Preferred equity return due: $75,000 (10% of $750K). Cash to preferred equity: $75,000. Remaining after pref: $112,000. Cash to common equity: $112,000. Return on common equity: 14.9% ($112K on $750K). If NOI drops to $340,000: debt service still $238,000, leaving $102,000. Preferred equity still owed $75,000. Remaining for common equity: $27,000, a 3.6% return. The preferred return is a fixed hurdle. Common equity absorbs all the variability, both upside and downside.

Mezzanine Debt vs. Preferred Equity

Both fill the capital stack gap, but the structures differ in meaningful ways.

Mezzanine debt and preferred equity fill the gap between the senior loan and common equity. Mezz is a loan secured by ownership interests, preferred equity is an ownership stake with priority distributions. Both carry higher returns than senior debt and lower returns than common equity. For LP investors evaluating deals, understand which layer your capital occupies and what happens to your position when the deal underperforms.