Mezzanine Debt versus Preferred Equity: which investment structure is utilized by the subordinate capital provider is often determined by the regulatory and other circumstances and objectives of the senior lender and not the preferences of the subordinate capital provider.

This article will discuss situations where the use of preferred equity in lieu of mezzanine debt is required and key concerns that the subordinate capital provider must consider with respect to such preferred equity investment.

Threshold Issue: Why Preferred Equity and Not Mezzanine Debt? There are many factors and circumstances that are evaluated in determining which subordinate capital structure the senior lender will require. At present the two most common factors that result in a preferred equity investment being required instead of mezzanine debt involve (1) the origination of a CMBS mortgage loan, which will be securitized and subject to rating agency scrutiny, and (2) for balance sheet lenders, avoiding their commercial real estate construction loan from being classified as a High Volatility Commercial Real Estate (HVCRE) loan, which requires that the balance sheet lender maintain an additional 50 percent of capital reserves. The new HVCRE regulations require that the mortgage borrower contribute at the closing of any “acquisition, development or construction” loan, and maintain while the loan remains outstanding (or is converted to a “permanent loan”), capital in an amount equal to at least 15 percent of the real estate's “as completed” appraised value (counting only the historical cost basis of the real estate and not any subsequent appreciation). Although interpretations of the new HVCRE regulations are still evolving, numerous banking institutions have concluded that a preferred equity investment (fully advanced at closing with any excess funds not utilized at closing being held by the mortgage borrower) is permitted to be counted as part of the mortgage borrower's capital contribution requirement, while, mezzanine debt is not permitted to be counted.