Investors often cannot finance a commercial real estate deal on their own. Instead, they look to a variety of capital sources to pay for a deal. Known as the deal’s “capital stack,” these diverse sources of debt and equity allow investors to translate good ideas into reality. But, each funding source in the capital stack has pros and cons. We’ll use this article to compare two common sources of capital: preferred equity vs mezzanine debt.
Specifically, we’ll discuss the following topics:
- Commercial Real Estate Capital Stack Overview
- Preferred Equity: Pros and Cons
- Mezzanine Debt: Pros and Cons
- Final Thoughts: Preferred Equity or Mezzanine Debt?
The Commercial Real Estate Capital Stack
Prior to discussing preferred equity and mezzanine debt, we need to cover the capital stack, in general. In commercial real estate, investors typically need multiple funding sources to make a deal happen. A deal’s capital stack refers to the specific composition of these different sources.
It helps to visualize a capital stack as a literal stack. On the top of the stack, you have the common equity. These are the funds that command the highest returns, but they also include the most risk. If a deal goes south, the common equity holders are the last to have their investment returned.
At the bottom of the capital stack, you have the senior debt. This is the first position mortgage loan. That is, the loan is actually secured by the underlying real estate. Accordingly, if the deal falls apart, the senior debt holder receives its cash back before anyone. As such, this capital has the lowest risk, but it also offers the lowest returns. While common equity investors may receive 15% or greater returns on their investments, senior debt (depending market conditions) falls more in the 3% to 6% range.
A variety of financing options exist between common equity and senior debt (e.g. junior debt, preferred equity, and mezzanine debt). From a visualization perspective, the “higher” you go on the capital stack, the greater your potential returns and risk. But, despite their differences, preferred equity and mezzanine debt largely fill the same purpose: bridging the gap between common equity capital and the senior mortgage to make a deal happen.
In the next two sections, we’ll provide an overview, pros, and cons of both financing sources from an investor’s perspective.
Preferred Equity: Pros and Cons
Overview
Preferred equity falls immediately below common equity on the capital stack. This position means that these investors receive slightly lower returns, but they also have greater protection than common equity holders – typically in terms of minimum required returns.
Pros
From an investor’s perspective, preferred equity offers two major advantages. First, it commands higher returns than any type of debt. Second, unlike common equity holders, preferred equity holders generally have a minimum required return. For example, with cash after debt service, preferred equity holders could receive 8% on their investment before any distributions to common equity holders.
Cons
The major con to preferred equity involves risk. As equity members, these investors fall below all debt holders in case of bankruptcy. If a deal collapses, the lenders can foreclose on the property. Any funds from foreclosure would first go to the senior debt holders, then the junior debt holders, and next any equity holders. This means that preferred equity holders could potentially lose their entire investment in a poorly planned or managed deal.
Mezzanine Debt: Pros and Cons
Overview
Like preferred equity, mezzanine debt 1) falls between common equity and senior debt on the capital stack, and 2) serves as a way to fund the gap between these two financing sources. However, unlike preferred equity, mezzanine debt investors actually hold a lien on the property. Frequently, this debt takes the second position mortgage. This means that, in the event of bankruptcy, the mezzanine debt holders will have their capital returned immediately following the senior debt.
Pros
Mezzanine debt offers investors higher returns than a first position mortgage, making this a particularly attractive investment in low-interest-rate environments. And, as a form of debt, this financing source also offers investors more security than any equity investments. If the deal collapses, mezzanine debt holders will recoup their capital prior to any equity investor.
Cons
What mezzanine debt gains in security it sacrifices in upside. Yes, mezzanine debt commands higher returns than senior debt. But, in many instances, these debt terms include a fixed rate. For instance, a mezzanine debt note may call for 6% returns over a five-year term. If the deal generates 20% returns, though, the mezzanine debt holders don’t collect any of that upside performance.
NOTE: Some mezzanine debt is structured as a hybrid instrument, allowing holders an option to convert their debt into equity in certain situations.
Final Thoughts: Preferred Equity or Mezzanine Debt?
So what’s better, preferred equity or mezzanine debt? The answer largely depends on your priorities as an investor. If concerned with minimizing risk while earning predictable returns, mezzanine debt likely makes sense. On the other hand, if you want to share in a deal’s potential upside and can stomach more risk, you may want to consider preferred equity.
Regardless of your preferences, if you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.