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Mezzanine vs preferred equity: which costs the sponsor more?

The coupon is the smallest part of the comparison. Compounding, the term and what each instrument does to the senior loan decide it.

Julian R. Sterling · from Private Equity Real Estate

On coupon alone, preferred equity at 9 per cent is cheaper than mezzanine at 11 per cent: on $15M of junior capital accruing over a three-year build, mezzanine costs $5.51M against $4.43M, $1.09M more. The real comparison includes the senior loan. If a mezzanine behind it makes the senior lender cut from 65 to 60 per cent of cost, pref stays cheaper up to a coupon of 11.96 per cent.

Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

The assumptions

The stack is the four-layer development stack of Private Equity Real Estate: $100M of cost, a construction loan at 65 per cent, $10M of mezzanine at 11 per cent, $5M of preferred equity at 9 per cent and $20M of common equity. The question here is what happens if the whole $15M junior slice is raised one way or the other. Rates are the chapter's; the 8 per cent senior rate, the three-year term and the senior cut are illustrative inputs from the companion workbook. Nothing is paid current during construction, so every layer accrues and compounds annually.

$100M development stack, junior slice raised as one instrument

Layer	Pref route	Mezz route	Rate
Construction loan	$65M	$65M or $60M	8%
Junior capital	$15M pref	$15M or $20M mezz	9% / 11%
Common equity	$20M	$20M	residual
Total	$100M	$100M

Step 1: the coupon

The difference is $1.09M. Simple interest understates it: $1.65M a year of mezzanine against $1.35M of pref is $4.95M against $4.05M over three years, but in a construction loan nothing is paid in cash and both balances compound. At the end of the build the sponsor owes $20.51M to the mezzanine lender or $19.43M to the pref investor, all of it ahead of the common equity.

Step 2: what the mezzanine does to the senior loan

A mezzanine loan is debt secured on the ownership interest, and it needs an intercreditor agreement that the senior lender has to sign. Some senior lenders respond by sizing down. Preferred equity is equity in form: it sits in the borrower's capital, usually does not count as debt for the senior lender, and needs no intercreditor. Take the illustrative case in which the senior lends 60 per cent instead of 65 if a mezzanine sits behind it. The mezzanine then has to be $20M, not $15M.

Total financing cost of everything ahead of the common equity, three years compounded

Route	Senior cost	Junior cost	Total
Pref at 9%, senior at 65%	$16.88M	$4.43M	$21.31M
Mezz at 11%, senior unchanged	$16.88M	$5.51M	$22.40M
Mezz at 11%, senior cut to 60%	$15.58M	$7.35M	$22.94M

The senior cut adds another $0.54M, because $5M moves from an 8 per cent layer to an 11 per cent one. Against pref, the mezzanine route now costs $1.63M more over the build.

Step 3: the break-even pref coupon

Pref is not always priced below mezzanine: the chapter gives ranges of 8 to 14 per cent for mezzanine and 8 to 12 per cent for preferred equity. So the useful number is the pref coupon at which the two routes cost the same.

Pref route against the two mezzanine routes, by pref coupon (positive means pref costs more)

Pref coupon	Pref cost	vs mezz, senior unchanged	vs mezz, senior cut
9%	$4.43M	-$1.09M	-$1.63M
10%	$4.97M	-$0.55M	-$1.09M
11%	$5.51M	$0.00M	-$0.54M
12%	$6.07M	+$0.56M	+$0.02M
13%	$6.64M	+$1.13M	+$0.59M

If the senior lender ignores the mezzanine, break-even is simply the mezzanine rate, 11.00 per cent. If it cuts five points of leverage, break-even rises to 11.96 per cent: a pref investor can charge almost a full point more than the mezzanine lender and still be the cheaper money. Term matters as much as rate. The $1.09M gap at three years is $0.66M over two years and $2.20M over five, so a delayed lease-up widens it.

The common mistake

The usual mistake is to compare coupons and stop. Three things change the answer. First, compounding: on a three-year accrual the coupon gap is $1.09M, not the $0.90M that simple interest suggests. Second, the senior loan: a structure that costs leverage at the top of the stack must carry that cost. Third, rights. A mezzanine lender can foreclose on the ownership interest and take control quickly; a pref investor usually has a preference and governance rights instead. Neither is priced in the table, and in a workout they dominate. If the pref also carries a share of profits, that participation has to be priced on the same compounded basis before any comparison is fair.

Both layers rank ahead of the common equity. On the book's own stack the priority layers cost $6.75M a year, a blended 8.44 per cent on the first 80 per cent of the capital, so the project needs a 6.75 per cent yield on cost before the common equity earns anything.

Takeaway

• Compare junior capital on accrued, compounded cost over the real term, not on the headline coupon.
• Include what each instrument does to senior proceeds; here it moves the break-even from 11.00 to 11.96 per cent.
• Price any profit participation before comparing.
• Then decide on control: the cheaper route on paper may be the one that can take the asset.

Both of the book's stacks, the leverage ladder and the mezzanine against pref comparison are live in the free workbook for this case. For how gearing feeds through to the equity itself, see how much 70 per cent LTV amplifies equity returns.

Questions readers ask

Is preferred equity cheaper than mezzanine debt?

It depends on the coupon and on the senior loan. At 9 per cent against 11 per cent, $15M of pref costs $1.09M less than mezzanine over a three-year accrual. If a mezzanine also makes the senior lender cut proceeds by five points, pref remains cheaper up to an 11.96 per cent coupon.

Why might a senior lender lend less when there is mezzanine debt?

Mezzanine is debt secured on the ownership interest and needs an intercreditor agreement, so the senior lender sees combined leverage and a second creditor able to take control. Some lenders size down in response. Preferred equity usually does not count as debt for the senior lender and needs no intercreditor.

Should mezzanine and pref costs be compared with simple or compound interest?

Compound, when nothing is paid current during construction. On $15M over three years the simple-interest gap between 11 and 9 per cent is $0.90M; compounded it is $1.09M. Over five years the compounded gap reaches $2.20M.

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