Preferred Equity and Mezzanine Debt

Quite frequently, a well-structured syndication finances a project using a variety of components such as preferred equity and mezzanine debt, which offer investors different levels of risk and return potential. 

This article will delve into the mechanics of how preferred equity and mezzanine debt work in real estate syndications and the advantages and disadvantages of each. You can also watch this short video by our CEO to get an overview: 

What is preferred equity?

Preferred equity is a type of investment that represents an ownership stake in an entity, be it a publicly-traded company or commercial real estate investment. In comparison to common equity, preferred shareholders enjoy fixed dividend payments, priority in receiving dividends before common shareholders, as well as possibly larger dividends. 

But it comes with some trade-offs — preferred shareholders do not have any influence over decision-making, a privilege held by common shareholders. This type of investment is especially attractive for investors who seek consistent income and lower risk compared to investing in common equity. Real estate preferred equity investments, specifically, can provide a stream of income and regularly scheduled payments, while lifting some of the downside risk.

Comparison table common equity vs. preferred equity

We summarized a comparison between common equity and preferred equity in the table below:

What is mezzanine debt?

Mezzanine debt is a hybrid form of financing that combines elements of both debt and equity. It is subordinate to senior debt but ranks above common and preferred equity in a company’s capital structure. Mezzanine loans typically carry higher yields than ordinary debt and are often unsecured, with no amortization of the principal. Depending on the jurisdiction, interest payments on mezzanine debt may also be tax-deductible.

Option for mid-sized businesses

Many mid-sized companies turn to mezzanine financing to fund their business, and acquisitions and to bridge the gap between what is available through debt financing and what is needed to support their growth with equity.

Yet with its positive aspects come some obstacles, including possible covenants and a higher interest rate. On top of that, business owners must be willing to let go of a certain level of control when opting for mezzanine debt as there are usually certain agreements with lenders that need to be respected. Mezzanine debt thus provides companies with a flexible option to gain the capital needed in addition to loans and equity. 

Differences between senior debt and mezzanine debt

Businesses have the option to access two distinct forms of financing: senior debt and mezzanine debt. Although both take the form of a loan and are used to fund the same causes, the differences between them are pronounced. 

Senior debt is typically provided by banks and financial institutions, and secured against the borrower’s assets. Such loans are prioritized in the event of any sort of bankruptcy or liquidation, meaning that senior debt holders are the first to receive repayment. 

Mezzanine debt offers lenders greater potential returns through the inclusion of additional terms, for example allowing them the option to convert their debt into equity at a later date. As it is providing an upside connected to the company’s future, the higher risk profile of this type of debt is accompanied by higher interest rates than regular senior debt and behaviors more akin to equity than conventional loans.

Comparison table mezzanine debt vs. senior debt

In a nutshell, when a bank provides senior debt, it is a secured loan with interest rates and the borrower must adhere to stringent criteria. With mezzanine debt, there is a higher risk factor and more flexibility. 

Companies often use both types of financing in tandem to maximize capital-raising potential and fuel growth/acquisitions.

Why GP’s use preferred equity

General partners (GPs) in syndicated real estate often utilize preferred equity as a strategic financing tool for several reasons, including easier access to capital and increased returns for common equity investors.

Access to additional capital

Preferred equity is generally more accessible than other forms of financing, such as senior debt or mezzanine loans. This financing is an obvious choice for most general partners (GPs). As compared to senior debt or mezzanine loans, preferred equity can come from diverse sources such as family offices, individuals, and funds. This broadens the capital-raising capabilities of GPs, offering more flexibility.

Flexibility in the capital stack

Preferred equity can be strategically implemented into a real estate project at varying levels, granting GPs the ability to craft a financing structure that’s best suited to their unique needs. With this type of flexibility, sponsors, and developers are able to bring their capital stack into more optimal form and consequently enhance the overall financing structure.

Increases returns for common equity 

If a project performs well, preferred equity can enhance returns for common equity. On the other hand, should a real estate project fall short of expectations without having a too bad result, those holding preferred equity are more protected than common equity because of their seniority.

By allocating different types of investors to different exit periods, GPs can strategically manage the risk and maximize returns over the lifetime of the real estate project. 

In summary, GPs in syndicated real estate often turn to preferred equity as a viable financing solution for several reasons. For starters, preferred equity is a more readily available form of capital compared to other offerings, thus making it a more appealing choice for syndication. What’s more, it can enhance returns to common equity investors.

Risks of preferred equity

Investors seeking fixed returns may consider investing in preferred equity, yet there are risks associated with such an investment that necessitate careful consideration. One such risk is taking on a considerable amount of leverage, which can make the investor vulnerable to market fluctuations. 

Another risk is that the General Partner (GP) may not provide enough of their own capital in the syndication, thus not fully committing to the success of the project. Prospective investors should be aware of all of the potential risks before committing their own capital.

Too much leverage

Real estate syndications leverage properties to enhance returns, but this strategy can come with risks. While leverage amplifies potential gains, it can also lead to financial distress if the cash flow from a property is not enough to cover its debt payments (and interest to preferred equity). During times of market downturns, the risk of over-leveraging increases, as do the possibilities of preferred equity investors not getting their expected returns or even losing all of their investment. Proper risk management is therefore key to reducing the chance of losses due to leverage-induced financial distress.

Investors who want to protect themselves from the perils of over-leveraging should look closely at a property’s loan-to-value (LTV) ratio and debt service coverage ratio (DSCR) before investing. Statistically, a lower LTV and higher DSCR mean the financing was handled with extra care, reducing the possibility of defaulting. For further security, diversification is key; investing in various assets, markets, and sponsors can help minimize risks.

LPs should make sure to read the private placement memorandum (PPM) and operating agreement when investing in syndication with preferred equity to make sure they understand the risks involved. 

Lack of control

Preferred equity investors in a real estate project often have limited say in how it is managed. In such circumstances, they must lean upon the expertise and judgment of those running the syndication, even if their preferences don’t necessarily line up with the decisions made. This can be a difficult situation to navigate, leaving them without the type of control they may have hoped for.

Too little skin in the game by GP

The deal sponsor’s equity stake in a real estate syndication is of the utmost importance. Having skin in the game provides the GP with an incentive to work hard with the intent of delivering maximum returns. From identifying the property and leading the acquisition process to oversee its management and eventual sale, their role is critical for a successful venture. When the GP stands to gain from the deal, it ensures that everyone is pulling in the same direction.

Investors should be aware that if the GP does not invest a significant amount of their own capital in the project, it may raise questions about their level of commitment to the undertaking. Consequently, this misalignment of interests could lead to excessive risk-taking and potential conflicts of interest. 

To mitigate this risk, it is essential to properly scrutinize the GP’s background, experience, and monetary involvement. A well-known and seasoned GP with significant equity involvement in the project is more likely to act in the best interests of all investors. 

Takeaway

When it comes to investing in preferred equity for a syndication, the main thing to remember is to review all agreements to understand all risk factors and make sure the General Partner doesn’t introduce too much leverage with debt and preferred equity.