Filling the Gap: Mezzanine Debt & Preferred Equity

In an ideal world, a senior construction loan and your own equity would cover 100% of project costs. In reality, senior lenders often cap out at 60-65% LTC, leaving a significant gap. This is where mezzanine debt and preferred equity come into play.

The Capital Stack Hierarchy

To understand these tools, you must visualize the capital stack. Risk and return increase as you move up the stack:

1. Senior Debt: First mortgage, lowest risk, lowest rate (e.g., SOFR + 250-300 bps).
2. Mezzanine Debt / Preferred Equity: The "gap" funding, moderate risk, higher rate (e.g., 10-15%).
3. Common Equity: First loss position, highest risk, highest targeted return (e.g., 20%+ IRR).

Mezzanine Debt

Mezzanine debt is a loan that sits subordinate to the senior mortgage. Crucially, it is not secured by the real estate itself (the senior lender won't allow a second mortgage). Instead, it is secured by a pledge of equity interests in the property owner entity.

• Foreclosure: If you default, the mezz lender forecloses on your LLC membership interests, effectively taking over the company and the property in a matter of weeks (UCC foreclosure), bypassing the lengthy judicial foreclosure process.
• Intercreditor Agreement: A complex document governing the relationship between the senior and mezz lender. Negotiating this is often the hardest part of the closing.

Preferred Equity

Preferred Equity (Pref Equity) is technically an equity investment, not a loan. The investor becomes a member of your LLC with a priority right to cash flow.

• Structure: "Hard" Pref (mandatory current payments, acts like debt) vs. "Soft" Pref (accrues if cash flow isn't available).
• Remedies: If you fail to pay the preferred return or redeem them by a certain date, they may have the right to remove you as the manager and take over the project.
• Lender Preference: Senior lenders often prefer Pref Equity over Mezz Debt because it sits within the borrower entity and doesn't complicate the collateral structure as much.

Cost of Capital

This capital is expensive, typically pricing in the 10% to 15% range (or higher for high-leverage construction deals). However, it is cheaper than bringing in a common equity partner who will demand a 20%+ return and a share of the upside (promote). Mezz/Pref providers generally do not participate in the upside; their return is capped.