Playing Center Field – Preferred Equity and Mezzanine Debt
A few months ago, we helped you demystify the capital stack and illustrated the risk/reward investment spectrum for real estate investments. Subsequently, we rang in the New Year with a deeper dive into the three senior debt products RealtyMogul.com investors can invest in. Since we last focused on the bottom of the capital stack, today we will trend up and examine its middle - mezzanine debt (or “mezz debt”) and preferred equity.
Mezz debt and preferred equity both serve primarily to increase total leverage for a real estate investment above what the senior lender is willing to provide, and thus reduce the common equity required by the buyer/owner of the property. Since mezz debt and preferred equity are both subordinate to senior debt, they are subject to a loss of interest or principal before the senior debt incurs any losses should the property underperform or default. To compensate for this increased risk, these products typically receive a higher coupon rate than the senior note.
Legally, Not So Much
While the financial features of mezz debt and preferred equity are similar (in terms of their position in the stack and range of expected return), the legal characteristics are not. The primary differences between the two are tied to the bundle of legal rights which accompany each and how each takes interest in a property.
A mezz lender will execute agreements with two parties - the senior lender and the common equity partner:
- The agreement with senior lender is accomplished through an intercreditor agreement, which establishes the mezz lender’s subordinate relationship to the senior lender.
- The agreement with the equity partner is accomplished through a mezz debt agreement, which establishes the relationship between the mezz lender and the common equity partner and grants the mezz lender a lien against the common equity partner’s interest in the entity which owns the property.
Preferred equity, on the other hand, generally secures its position in the capital stack by taking an ownership stake in the property-holding entity itself through an agreement with the common equity partner. Generally, there is no formal agreement directly between preferred equity and the senior lender, although the senior lender may require the right to review and approve the preferred equity documents.
Now that we got some high level legal jargon out of the way, let’s take a closer look at the different products and their respective agreements separately.
As mentioned above, mezz debt secures its position in the capital stack, which is subordinated to the senior debt but senior to all equity, via agreements with both the senior lender and the common equity partner.
Intercreditor Agreement – Senior Lender
The agreement between the mezz lender and senior lender, known as an intercreditor agreement, serves as a proxy to the loan agreement between the two parties. The intercreditor agreement acknowledges any and all of a mezz lender’s rights or cures in the instance of a mezz default. It also lays out structured communication between the senior lender and the mezz lender if such default occurs.
While the mezz lender will be granted some rights by the senior lender, the senior lender will generally not allow a range of cures of default rights equivalent to what the senior lender enjoys itself. Instead, the senior lender will normally put a series of requirements in-place which must be met before the mezz lender may pursue a foreclosure.
For example, the senior lender may require that the mezz lender pay all unpaid interest owed to the senior lender before the mezz lender can initiate foreclosure on the equity partner.
Mezz Debt Agreement - Equity
In addition to the intercreditor agreement with the senior lender, mezz lenders will negotiate a mezz debt agreement with the common equity partner. The mezz debt agreement, which creates the relationship between the mezz lender and the common equity partner, establishes the coupon due to the mezz lender and lists all instances of default by the equity against the mezz lender. To secure its interest, the mezz lender is granted a lien against the entity which owns the property and is controlled by the common equity partner.
Unlike mezz debt’s dual relationship with both the senior lender and the equity, generally preferred equity will only execute documents to establish a relationship with the common equity partner. The agreement grants the preferred equity holders a proportional ownership stake in the property-holding entity based on the amount of preferred equity they invested out of total equity. However, with no lien against the property (like the senior lender has) or the entity which holds title to the property (like the mezz lender has), the preferred equity is subordinate to both of the senior and mezz lenders.
What it all Means to You as an Investor
Mezz debt and preferred equity both represent a means for common equity holders to increase transaction leverage levels, and therefore potential upside returns and downside risks, higher than they otherwise would be able to if they only had a senior loan in-place.
While each real estate transaction is unique and requires special consideration to be properly capitalized, certain transactions better lend themselves to “mid-capital stack” sources of financings:
- Due to the higher level of legal negotiation required, mezz debt does not normally make sense for smaller transactions, as legal bills associated with negotiating intercreditor agreements can rack up quite quickly.
- Due to the higher coupon which preferred equity normally pays, it is often not a great fit for real estate investment opportunities which have significantly deferred cash-flow characteristics.
RealtyMogul.com considers each real estate opportunity on an individual basis and offers financing opportunities which we believe make sense for the asset and represent attractive risk-adjusted investment opportunities for our investors. Mezz loans and preferred equity financings are two more investment tools which we offer our investors to diversify their real estate portfolios across the risk spectrum.
Want to learn more about mezz debt and preferred equity investment opportunities available through RealtyMogul.com? Call us today .
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