Preferred Equity vs Mezzanine Debt: Choosing the Right Capital for Your Deal

When senior debt doesn't provide enough leverage to close a commercial real estate transaction, sponsors often turn to subordinate capital to fill the gap. The two most common options—preferred equity and mezzanine debt—occupy similar positions in the capital stack and target comparable returns, but they're structured very differently and carry distinct implications for control, risk, and flexibility.

Understanding the differences between preferred equity and mezzanine debt helps sponsors choose the right tool for each transaction and negotiate better terms with capital providers.

Where They Fit in the Capital Stack

Both preferred equity and mezzanine debt sit between senior debt and common equity—providing capital when a project needs more leverage than a first mortgage alone can provide.

A typical capital stack using subordinate capital might look like:

• Senior Debt: 60–65% LTC
• Mezzanine Debt or Preferred Equity: 10–20% LTC
• Common Equity: 15–30% LTC

Both forms of capital allow sponsors to increase total leverage while limiting the amount of common equity required—but each comes with different legal structures, remedies, and risk profiles.

The Fundamental Difference: Debt vs. Equity

The core distinction is structural:

• Mezzanine debt is a loan—typically secured by a pledge of equity interests in the property-owning entity rather than a mortgage on the real estate itself.
• Preferred equity is an ownership interest—structured as a membership interest in the entity that owns the property, with priority over common equity holders in distributions.

This difference affects foreclosure rights, tax treatment, accounting, and lender approval processes.

Collateral and Foreclosure Rights

Mezzanine debt is secured by a pledge of the ownership interests in the borrowing entity. If the sponsor defaults, the mezzanine lender can execute a UCC foreclosure on the pledged equity—a faster process than real estate foreclosure in most states. This gives mezzanine lenders a relatively efficient path to taking control of the property-owning entity.

Preferred equity doesn't have traditional foreclosure rights. Instead, it relies on contractual remedies built into the operating agreement—such as the right to remove the sponsor as managing member, block distributions, or trigger a forced sale. These remedies can still be powerful, but they depend heavily on how the deal is documented.

Return Structure and Pricing

Both mezzanine debt and preferred equity typically target returns in the 12–18% range, but they're structured differently:

• Mezzanine debt earns interest—usually a combination of current pay and accrued (PIK) interest. The lender has no participation in upside.
• Preferred equity earns a preferred return—often structured as a fixed accrual that must be paid before common equity receives distributions. Some preferred equity also includes a small participation in profits above a certain threshold.

In practice, all-in yields are comparable, though preferred equity pricing may be slightly higher to compensate for weaker enforcement remedies.

Key Structural Considerations

When to Use Mezzanine Debt

Mezzanine debt tends to work well in situations where:

• The senior lender is comfortable with subordinate debt and willing to negotiate an intercreditor agreement
• The sponsor prefers a clean debt/equity separation in the capital structure
• The mezzanine provider wants enforceable collateral and efficient remedies
• Interest deductibility is important for tax planning

When to Use Preferred Equity

Preferred equity is often preferred (pun intended) when:

• The senior lender prohibits subordinate debt or won't negotiate an intercreditor agreement
• The sponsor wants to maintain lower reported leverage ratios
• The capital provider wants to avoid lender liability exposure
• The transaction requires flexibility in structuring returns or participation

Many institutional lenders—especially CMBS and agency lenders—restrict or prohibit mezzanine debt, making preferred equity the only subordinate capital option in certain deals.

Hybrid Structures and Variations

In practice, many deals blend elements of both:

• Preferred equity with hard rights—structured to include UCC-like remedies, making it behave more like mezzanine debt while still being classified as equity
• Participating preferred equity—includes upside participation alongside a fixed preferred return
• Convertible mezzanine—mezzanine debt with an option to convert into equity under certain conditions

The line between mezzanine and preferred equity has blurred, and experienced sponsors often negotiate custom structures depending on capital availability and senior lender restrictions.

Risks and Considerations for Sponsors

Regardless of structure, subordinate capital comes with trade-offs:

• Higher all-in cost of capital—mezzanine and preferred equity are more expensive than senior debt
• Increased execution risk—adding another capital partner increases complexity and negotiation time
• Control provisions—both mezzanine lenders and preferred equity holders may require approval rights over major decisions
• Intercreditor complexity—for mezzanine debt, negotiating the intercreditor agreement can delay closings

Sponsors should weigh the additional leverage against the cost and complexity before adding subordinate capital to a transaction.

Choosing the Right Structure

There's no universal answer to whether mezzanine debt or preferred equity is better—it depends on:

• What the senior lender allows
• How the sponsor wants to report leverage
• Tax considerations and deductibility
• The capital provider's preferences for collateral and remedies
• Execution timeline and negotiation capacity

Experienced capital advisors can help sponsors evaluate both options, identify which providers are active for a specific deal profile, and structure terms that balance cost, control, and execution risk.

Brookmont Capital Ventures is a capital advisory firm. We do not provide direct lending or investment services. All financing is subject to capital provider approval and underwriting.