What's in a Name: Mezzanine Debt Versus Preferred Equity

Abstract

Mezzanine loans and preferred equity interests are both forms of investment in commercial properties; they are favored by investors, particularly institutional investors, that want a fixed, or at least floored, return and priority as to both their return on and return of investment. In its most common form, a mezzanine loan is secured by the investment property, but only indirectly, by a pledge of the equity in the entity (usually a limited liability company or limited partnership) that owns the property. Preferred equity, on the other hand, usually takes the form of a direct equity investment in the property owner, with a fixed, preferential return that is paid prior to distributions to the “common” equity interests in the owner. Apart from this difference, mezzanine debt and preferred equity can -- and often do -- have similar terms and conditions; nonetheless, institutional and other real estate investors appear generally to regard mezzanine debt as an intrinsically better form of investment than preferred equity. The article postulates that capital markets may be giving undue deference to the notion that one is “debt” and the other is “equity” and analyzes each of the presumed legal advantages of mezzanine loans over preferred equity interests. While acknowledging that for certain type of investors and certain types of properties, mezzanine debt may be the preferable form of investment, the article concludes that, overall, preferred equity provides an investment structure that works as well as -- and in some cases better than -- mezzanine debt.

Published verison of paper varies slightly from SSRN version.

Keywords: preferred equity, mezzanine loans, real estate investment

JEL Classification: K11, K12