Mezzanine debt vs preferred equity: how do they differ?

How do mezzanine debt and preferred equity compare?

Both fill the gap between the senior loan and the sponsor's common equity, and both rank ahead of common equity. The capital stack guide covers where they sit. This page covers what actually differs once the documents are signed.

What rights does each investor get before a default?

A mezzanine lender's day-to-day rights come from loan covenants: reporting, budget approval on larger items, leasing approval above set thresholds, limits on new debt and transfers, and often cash management that mirrors the senior loan. The sponsor stays in control of the company as long as the loan performs.

A preferred equity investor is an owner, so its rights are written as major decision approvals inside the operating agreement. Those lists can reach further than loan covenants, including refinancing, sale, budgets, and replacement of the property manager. The more the preferred return depends on accruals, the more approval rights the investor tends to ask for. See preferred equity and mezzanine financing for the definitions.

How do remedies work after a default?

Mezzanine remedies run through Article 9 of the Uniform Commercial Code. After a default, the lender can sell the pledged ownership interests in a commercially reasonable sale, often buying them itself, and take control of the property owner without a mortgage foreclosure. The intercreditor agreement sets the conditions, which typically include curing senior defaults and bringing in a replacement guarantor acceptable to the senior lender.

Preferred equity remedies are whatever the operating agreement says. Common triggers are a missed preferred return, a missed redemption date, or a sponsor bad act. Common remedies are removal of the managing member, conversion to full control, or a forced sale. How well they work depends on the drafting, the senior lender's consent to a change of control, and state law on the entity. A sponsor facing either remedy loses control of the asset, so the triggers deserve as much negotiation as the return.

Intercreditor agreement vs operating agreement

The intercreditor agreement is a contract between the senior lender and the mezzanine lender. It covers notice of defaults, cure rights, the mezzanine lender's option to buy the senior loan, who qualifies to own the property after a mezzanine foreclosure, and limits on amending the senior loan. The sponsor is not usually a party, yet its terms decide what happens to the sponsor's interest.

Preferred equity has no intercreditor agreement by default. The senior lender may require a recognition agreement that approves the preferred investor as a potential controlling owner. Everything between the sponsor and the investor sits in the operating agreement, which gives both sides more room to tailor terms and more ways to get them wrong.

Does the senior lender have to consent?

For mezzanine debt, almost always. Senior loan documents usually prohibit pledges of ownership interests without approval, and the senior lender will want to negotiate the intercreditor agreement. Some senior loans prohibit mezzanine debt outright.

Preferred equity can sometimes fit inside a senior loan's permitted transfer provisions, which is one reason sponsors use it. Many senior lenders still restrict preferred equity that carries a mandatory redemption, a fixed payment, or change-of-control rights, and treat it like debt. Read the transfer, due-on-sale, and additional indebtedness sections before choosing a structure.

How is each taxed?

Mezzanine interest is interest expense of the borrowing entity and income to the lender, subject to the interest deduction rules that apply to the borrower. Preferred equity returns flow through partnership allocations and distributions, which changes how income and losses are shared and how the investor reports them. The right answer depends on the partnership's tax profile, so bring the sponsor's tax advisor in before the term sheet is final.

Worked example: coverage with each structure

In this hypothetical example, a property earns $2,400,000 of net operating income and carries a $24,000,000 senior loan at a hypothetical 6.25% interest-only rate, or $1,500,000 of annual interest. The sponsor needs $6,000,000 more. The mezzanine option charges a hypothetical 12% paid currently. The preferred equity option carries a hypothetical 12% preferred return, with 8% paid currently and 4% accrued.

Senior coverage is 1.60x either way. With mezzanine debt, cash paid to the subordinate capital is $720,000 and coverage after both layers falls to 1.08x. With preferred equity, current distributions are $480,000, coverage after both layers is 1.21x, and $240,000 accrues each year for payment at a sale or refinance. Run your own numbers in the DSCR calculator.

Which one fits your deal

These hypothetical situations show how the choice usually breaks.

• The senior loan documents prohibit pledges of ownership interests: preferred equity, structured to fit the permitted transfer language.
• A stabilized property with steady cash flow where the sponsor wants a fixed cost, a clear maturity, and full control short of default: mezzanine debt.
• A development or heavy renovation with no cash flow during the work: preferred equity with an accrued return, or mezzanine debt carried by its own interest reserve.
• A recapitalization that returns part of the sponsor's equity on a stabilized asset: mezzanine debt is usually the more direct fit.
• An investor that wants a share of the profits along with a priority return: preferred equity with a participation, or a move to JV equity if the ask grows.

How Capital Partners structures the gap

The right answer starts with the senior loan documents, the size of the gap, and how much control the sponsor can share. Capital Partners places mezzanine debt and preferred equity alongside senior financing from $1M to $100M. Submit the deal with the senior term sheet and the sources and uses, and a principal will review which structure the senior lender and the business plan will support.

Common questions