Real estate owners and developers have been increasingly turning toward preferred equity structures and investments in order to raise much needed capital for the purchase, renovation and development of real property where such capital is unavailable from traditional lending sources. Historically, these shortfalls in capital were often funded through subordinate and mezzanine financing. One reason for the increase in preferred equity investments is likely due to the distaste of some mortgage lenders in making mortgage loans where there is or will be subordinate or mezzanine financing in place. However, preferred equity investments are often structured essentially as disguised mezzanine and subordinate financing wherein the third-party investor is promised a certain return on its investment and granted remedies, much like a secured lender, in the event the investment is not repaid in a specified period of time.
Mezzanine Debt vs. Preferred Equity
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.
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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