By Andrew Hanzl
Since the beginning of Metropolitan Capital Advisors some 26 years ago and even dating back further to the creation of the modern mortgage 500 years ago, clients and borrowers have been asking the age-old question, “How can I borrow more money?” The question’s especially true in today’s lending environment where senior lenders are more disciplined, and loan-to-cost metrics are topping out at 60%-65% of the capital stack. Most borrowers either can’t or don’t want to fork over 35-40% of the required capital in the form of their own money, and certainly don’t want to give away a piece of the upside to an equity partner, so what gives?
Over the past few decades, sources of capital have gotten wiser by designing and perfecting financial tools that serve as a solution to bridge the gap between where the senior loan stops and where the common equity begins. Most the of time this subordinate capital fills between 10% to 30% of the capital with the last dollar in capped at around 85% of the total capital required. Two of the most common forms of this subordinate capital are Mezzanine Debt and Preferred Equity. To the untrained eye both mezzanine debt and preferred equity are very similar in nature in that they are subordinate to the senior loan, have payment priority to the common equity, and cost more than your senior loans interest rate but less than a potential joint venture equity partner.
Although accomplishing the same objective of obtaining higher leverage, when it comes to remedies, cost, flexibility, tax treatment, bankruptcy risk, and marketability, mezzanine debt can defer quite dramatically from preferred equity. Around this shop, we have closed our fair share of deals with a piece of mezzanine debt as well as preferred equity capital and thus understand the mechanics of each and when to prescribe one over the other to your capital stack. Let me give you a brief rundown of the basics.
Mezzanine debt is viewed as safer, and it’s structured a shade closer to a senior loan (i.e., stated maturity, fixed hard pay, personal guarantees, inter-creditor agreements, etc.) and generally in a more secure position in comparison to preferred equity. Typically, but not always, mezzanine lenders are pledged 100% of the equity interests in the financing vehicle as their security. This means when things go sideways the mezzanine lender can consummate a UCC foreclosure on the sponsor’s equity interest, and upon successful completion will stand in the shoes of the owner of the property. On the other hand, preferred equity investment is not secured in the strict sense, and foreclosure is not an available remedy. However, upon default, the preferred equity provider does have specific and tailored rights and remedies included in the operating agreement, which can range in magnitude. For example, preferred equity providers can have the right to take over management, force a sale of the property or the most extreme scenario to redeem all the common equity for a nominal sum and become the sole owner.
Since preferred equity is in a slightly riskier position, preferred equity prices marginally higher than mezzanine debt. For this additional risk preferred equity providers charge around 11%-16% (sometimes with profit participation), where mezzanine debt is priced with a fixed interest rate of 9%-12%. Of course, rates depend on a deal by deal dynamics, but these approximate rates will get you in the ballpark.
There are several other complicated factors to consider when deciding whether to pursue mezzanine debt or preferred equity such as tax treatment, bankruptcy risk, interaction with senior lender, etc. but hopefully you now have a basic understanding.
If you would like more information about preferred equity or mezzanine debt or would like assistance securing financing that incorporates a piece of either form of capital, please contact Andrew Hanzl at [email protected].
The Author, Andrew Hanzl, is a Senior Analyst in the Dallas Office of Metropolitan Capital Advisors.
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