The capital stack in one picture
Every property purchase is funded by layers of capital, ranked by who gets paid first and who absorbs losses first. From the most senior and lowest-cost to the most junior and highest-return, a typical apartment deal looks like this:
- Senior loan: a first-mortgage loan secured by the property, usually the largest layer and the cheapest. It is paid first from cash flow and sale proceeds.
- Mezzanine debt or preferred equity: a middle layer, more expensive than the senior loan, that is paid after the senior lender but before common equity.
- Common equity: the sponsor and limited partners. Paid last, absorbs losses first, and keeps the upside after everyone above it is paid.
How mezzanine debt works
Mezzanine debt is a loan, but it is not secured by the building. The senior lender holds the mortgage, so the mezzanine lender instead takes a pledge of the ownership interests in the entity that owns the property. If the borrower defaults, the mezzanine lender can foreclose on those ownership interests, typically through a Uniform Commercial Code sale, which can be much faster than a real estate foreclosure, and step into control of the property subject to the senior loan.
Mezzanine loans carry a fixed or floating interest rate, usually well above the senior loan rate, and a maturity date. The relationship with the senior lender is governed by an intercreditor agreement that limits what the mezzanine lender can do and when, and that often requires it to cure senior loan defaults before taking control.
How preferred equity works
Preferred equity is an ownership investment, not a loan. The preferred equity investor buys a class of interests in the property-owning entity, or a joint venture above it, with a right to receive a set return and its capital back before common equity receives anything. Some preferred equity is hard, with a mandatory redemption date and fixed payments that behave much like debt; some is soft, with payments that depend on available cash flow.
Because preferred equity is equity, its protections come from the operating agreement rather than a loan document. Typical remedies include the right to take over management of the entity, sometimes called a control flip, to force a sale or refinance, or to increase its ownership share if payments are missed. Many senior lenders that restrict mezzanine financing permit preferred equity, which is one reason it has become common in multifamily.
The key differences
The two often look similar on a term sheet, but they differ in ways that matter:
- Legal form: mezzanine is debt secured by a pledge of ownership interests; preferred equity is an ownership interest with priority.
- Remedies: mezzanine lenders foreclose on the pledged interests; preferred equity investors use rights in the operating agreement, such as removing the sponsor or forcing a sale.
- Senior lender consent: mezzanine debt generally requires an intercreditor agreement; preferred equity may need only a recognition agreement or lender approval of the joint venture terms.
- Tax treatment: mezzanine interest is generally deductible to the borrower and taxed as interest income to the lender. Preferred returns are allocations of partnership income and may be treated differently.
- Cost: both are priced well above senior debt and below the returns targeted by common equity. Exact pricing depends on leverage, the property and the market.
What it means for common equity investors
If you are a limited partner in a syndication, mezzanine debt or preferred equity sits ahead of you. It can raise your projected returns by reducing the common equity needed to buy the building, but it also increases total leverage and adds another party with the power to take control if payments are missed. In a downturn, the middle layer is protected until the common equity is wiped out.
When you review an offering, look at the total amount of capital ahead of you, the combined payment burden, maturity dates on every layer, and the remedies the preferred or mezzanine provider holds. A deal with a modest senior loan and no middle layer can be safer for common equity than one that looks better on projected returns.
Investing in the middle layer
Some investors choose to invest in preferred equity or mezzanine positions themselves, through funds or individual deals, to earn a more predictable return with a cushion of common equity beneath them. The trade-off is limited upside: the return is generally capped at the agreed rate, and gains above that go to common equity.
The protection is only as good as the cushion and the remedies. Check how much common equity sits below your position, the property’s value relative to all debt and preferred capital, and how realistic it would be to exercise your rights if the sponsor fails.
