Preferred Equity as Mezzanine Financing

Since modern mortgages were created some 500 years ago, real estate owners and developers have looked to increase their leverage further by financing their projects with capital that is junior to the mortgage debt, but senior to the owner/developer equity. Mezzanine loans and preferred equity investments are used to achieve this higher leverage. All things considered, is one better than the other?

Normally banks, life insurance companies and “conduit” lenders will not exceed 80% of loan-to-value when making commercial mortgage loans and since the great recession, that leverage has dropped even further often times to 70%. Mezzanine loans and preferred equity investments are added on top of these conventional loans to achieve loan-to-cost ratios as high as 95% and loan-to-value ratios as high as 90%.

What’s the Difference?

These two common subordinate financing structures – mezzanine loans and preferred equity -- are similar in certain fundamental respects. A second-position loan is simple enough to understand – sits behind a first lien, is secured by the property and also is often secured by the sponsor’s membership interests in the title-holding entity, so that if that entity fails to make its payments that 2nd-position lender quickly does a UCC foreclosure (a fast process) on the stock. If the lender owns the stock, it owns the commercial project as well going forward.

Preferred equity investments arose in part because of the distaste of some 1st-position lenders toward making mortgage loans where 2nd-position financing is also in place. This is because, among other things, of the need to require inter-creditor agreements that clarify the rights of the two lenders. Preferred equity, however, raises many of the same issues and pitfalls for financiers -- including potential transfers of controlling interests in management, as well as a lesser “cushion” being available for the repayment of their middle-tier interest.

A preferred equity investment sounds quite different than a mezzanine loan, but it accomplishes almost exactly the same thing. The lender makes an investment of equity with a preferred return in the title-holding entity that owns the project. If the entity fails to pay the preferred member the return, the old management is ousted and loses its voting rights, dividends, and right to the distribution of any profit -- and oftentimes any other common members of the entity go down with it.

How is it Structured?

Preferred equity investments in real estate transactions come in various forms and, unlike subordinate or mezzanine loans, are typically documented directly in the borrower's organizational documents. The investor gets an ownership interest in the title-holding entity that gives the investor a preferred/priority return on its investment. That investment has certain loan-like features, including: (i) “interest” on the investment that is required to be paid monthly by the “borrower” regardless of available property cash flow; (ii) the entire investment is required to be paid by a certain maturity date; (iii) default rate “interest” and penalties are assessed against the “borrower” in the event payments are not timely made; and (iv) a default in the repayment of investment potentially results in the loss of management and/or ownership control by the “borrower” in the company in favor of the investor or other third-party.

These “hard” structures (so called because the consequences are very real) can be compared to “soft” structures that may delay distributions until sufficient cash flow levels have been achieved, have looser repayment obligations, and eliminate some of the harsher remedies in the event of “default.”

Working with First-Position Lenders

Because of these similarities, first-position lenders now often inquire as to the details of what type of preferred equity structure is being contemplated. Both Freddie Mac and Fannie Mae require multi-family lenders, for example, to cause all sponsoring real estate companies to complete detailed analyses of any preferred equity structures to determine whether a "soft" or "hard" preferred equity structure is contemplated.

Sponsors need to similarly double-check that any primary loan documents do not prohibit preferred equity; violations of these covenants can sometimes result in recourse liability to any guarantors of the loan.

Preferred Equity Here to Stay

Notwithstanding the post-2008 retrenchment, the past few decades in particular have witnessed a boom in the creation of structures for capital that is junior to the mortgage debt but senior to the owner / developer equity. This need actually increased post-2008 as traditional mortgage lenders tightened up their underwriting standards, leaving sponsoring real estate companies scrambling for available capital. New lenders providing preferred equity and other mezzanine financing now have the opportunity to provide liquidity and additional capital to sponsoring real estate companies needing to fill the “financing gap” between the senior mortgage debt and the owner’s equity.