Mezzanine debt and preferred equity allow a borrower to increase leverage beyond what a traditional lender is able to offer. Mezzanine debt fits between the senior or first mortgage lender and common equity in the capital stack. Rather than having a first mortgage position in the real estate, the mezzanine lender will have a pledge in the entity that owns the real estate. Unlike mezzanine debt, preferred equity investors do not have a pledge in the entity that owns the real estate. Instead, preferred equity is usually a direct equity investment in the entity that owns the property. Preferred equity often has its own share class that has a preferential return paid prior to distributions to the common equity. While they both can be structured a number of different ways, preferred equity and mezzanine returns are typically capped at their initial principal investment plus accrued interest.
Both types of subordinate financing have similar terms and conditions and either can be used across a wide variety of situations, including construction and development, rescue capital, partnership recapitalizations or for investors who are looking for increased leveraged returns.