Chapter 9 : Mezzanine Debt and Preferred Equity in Real Estate

In the last 10 years, the commercial real estate market has witnessed drastic changes in the types and volume of nontraditional financing methods. Before the recession that began in late 2007, unprecedented growth took place in two types of non- traditional financing: mezzanine debt and preferred equity. During that time, real estate borrowers had easy access to capital with loan-to-value ratios that sometimes exceeded the value of the property, and lenders could earn high interest rates and fees from these riskier financings. In the years following the 2008 recession recession, however, traditional mortgage lenders imposed tighter underwriting standards, and real estate owners and developers competed for the limited sources of available capital. As a result, the need for alternative funding sources increased. This provided an opportunity for a new group of lenders to enter the market to provide liquidity and additional capital. These nonbank financial institutions and hedge funds (many with billions of dollars under management) looked for opportunities to provide real estate financing during the volatile time period immediately following Lehman's collapse and the ensuing financial meltdown and continue to do so now.With mezzanine debt and preferred equity investments, real estate owners could obtain much needed capital, and nonbank financial institutions and hedge funds could enter the finance markets and earn high interest rates and fees from these riskier and nontraditional financings. Real estate investors and scholars view these nontraditional financings (i.e., preferred equity and mezzanine debt) as a major way to fill the “financing gap” between the senior mortgage debt and the owner 's equity. This chapter discusses the risks and opportunities of these two types of nontraditional real estate financings. It also examines how investors effectively manage the inherent risks of, and create opportunities with, mezzanine loans and preferred equity investments.This chapter is organized as follows. The first part focuses on mezzanine loans and describes the legal and economic structure of mezzanine financings, along with the investment opportunities, and the business risks, of mezzanine loans. The second part focuses on preferred equity investments and also examines the legal and economic structure of these equity investments, along with the investment opportunities and risks of preferred equity