Mezz debt vs Pref Equity Modeling

[Anonymous]

Hello Spencer,

Would you consider discussing how to model Preferred Equity which could be an alternative way to Mezz debt?

Thanks,

Kyle

[Spencer Burton]

First a Couple of Definitions

Let me first say that you’ll see varying definitions of mezz debt and pref equity in real estate. What Michael and I define as “mezz debt”, some people call “pref equity”. So let me make sure we’re speaking the same language.

When I refer to mezzanine debt, I’m referring to “a debt instrument secured by the investment property, but only indirectly, by a pledge of the equity in the entity (usually a limited liability company or limited partnership) that owns the property”. I believe this to be the correct defnition of mezz debt (and the Stanford Law Journal agrees with me). You can also review this journal article on how foreclosure works with a mezzanine loan.

With that said, you’ll often find professionals with a slightly different definition of mezz debt (i.e. here’s one example), so it’s important I define the terms first.

So again, for purposes of this answer mezz debt is a debt instrument secured by the ownership entity. Pref equity on the other hand is a direct equity interest in the ownership entity. However, the pref equity owner is given priority over excess cash flow distributions and usually is only required to contribute its equity share after the common equity owners has made its required contribution.

So How to Model Mezz Debt vs. Pref Equity

So using the above definitions, preferred equity is modeled in your equity waterfall whereas mezzanine debt is modeled in your debt module. Or another way to think about it, mezz debt is a property-level cash flow, whereas pref equity is a partnership-level cash flow.

In terms of how to model preferred equity. It obviously depends on the terms of the pref equity. Typical pref equity in my experience is contributed after common equity, while distributions to the pref equity piece have priority over the common equity.

So modeling the contributions and distributions of the pref equity requires tracking its capital account, contributing from the pref equity only once the common equity has contributed its required share, and then distributing excess cash flow first to the pref equity before distributing to the common equity.

Spencer

[Author]

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