Probably from the time the modern mortgage was created some 500 years ago, real estate owners and developers have looked to increase their leverage and finance their projects with capital that is junior to the mortgage debt but senior to the owner/developer equity. Notwithstanding the post-2008 retrenchment, the past few decades in particular have witnessed a boom in the creation of structures for this junior capital, ranging from second mortgages (pure debt) to joint ventures (pure equity). This article examines two of the most common subordinate financing structures—mezzanine loans and preferred equity—and considers whether the real estate market’s general preference for “mezzanine debt” as opposed to preferred equity is warranted, or at least should be reconsidered.
Structure of Investments
Mezzanine loans and preferred equity are similar in certain fundamental respects. In each case, the owner or developer seeks capital from a third party, who is willing to provide such capital in exchange for a return commensurate with the increased risk profile of capital that is junior to the mortgage debt. In each case, the mezzanine lender or preferred equity investor (each, a ‘capital provider’) funds capital to a direct or indirect owner of the property (the ‘financing vehicle’).1 The capital provider is willing to be in a (structurally) subordinate position to a senior mortgage lender provided that it is granted an interest in the financing vehicle (rather than the property itself).
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