Preferred equity is an ownership interest in the borrowing entity that carries a stated preferred return and is paid before the common equity but after every lender. It is not a loan and holds no lien; its rights come from the operating agreement of the entity that owns the property.
Where does preferred equity sit in the capital stack?
The capital stack runs from the senior mortgage at the top, through any mezzanine loan, to preferred equity and then common equity at the bottom. Preferred equity is paid after every lender and before the sponsor’s own capital.
Illustrative example:
| Position | Amount | Share of total capitalization | Paid from cash flow |
|---|---|---|---|
| Senior mortgage | $60,000,000 | 60% | First |
| Mezzanine loan | $10,000,000 | 10% | Second |
| Preferred equity | $15,000,000 | 15% | Third |
| Common equity | $15,000,000 | 15% | Last |
The investor receives its preferred return only after both lenders are paid, and the common equity receives distributions only after the preferred return is current.
Sponsors use preferred equity to fill the gap between the debt the lenders will advance and the equity the sponsor wants to contribute, at a cost below common equity’s expected return. It is also used at refinance, when a new senior loan is smaller than the balloon payment on the maturing loan.
How does preferred equity differ from mezzanine debt?
Both fill the same gap in the stack and both are subordinate to the senior mortgage, but they are different instruments.
| Feature | Preferred equity | Mezzanine loan |
|---|---|---|
| Legal form | Membership or partnership interest in the owner | Loan to the owner’s parent entity |
| Collateral | None; rights arise from the operating agreement | Pledge of the ownership interests in the property owner |
| Return | Preferred return, current pay and accrued | Interest at a note rate |
| Remedy on non-payment | Removal of the managing member, control of the entity, forced sale or buyout | UCC foreclosure on the pledged interests |
| Relationship with senior lender | Recognition agreement, if any | Intercreditor agreement |
The distinction matters most to the senior lender. A mezzanine lender can take the borrower away from the sponsor through foreclosure. Preferred equity is inside the borrower, and the senior lender’s concern is whether it behaves like debt: a hard redemption date, a sponsor guaranty or a lien would make it debt in substance.
How do senior lenders treat preferred equity?
Senior loan documents restrict transfers of ownership interests in the borrower and restrict additional indebtedness. Admitting a preferred equity investor is a transfer of interests, so it requires the senior lender’s consent or must fit an exception the documents carry. Lenders commonly review the preferred equity documents and require that the investor hold no lien, no guaranty and no mandatory redemption before the senior loan matures.
Change of control is the second issue. If the preferred equity investor exercises its right to remove the sponsor and take control of the entity, that exercise is itself a transfer under the senior loan. Lenders address it in a recognition agreement that states the conditions under which the investor may take control, commonly a qualified transferee standard and a replacement guarantor, and gives the investor notice and cure rights on a senior default.
What protective provisions does preferred equity carry?
The investor’s protection comes from the operating agreement rather than from collateral. The common provisions are a preferred return that accrues when it is not paid currently, a redemption date by which the sponsor must return the investor’s capital, consent rights over major decisions such as sale, refinance and budget, and reporting obligations.
The central remedy is control. If the preferred return is not paid, the redemption date is missed or a covenant is breached, the investor may remove the sponsor as managing member, take over management of the entity and cause a sale or a refinance to recover its capital.
For the sponsor, these provisions read like a covenant package, and the preferred equity’s tests, dates and consent rights are tracked beside the senior loan’s own.
How preferred equity shows up in LoanBoss
LoanBoss handles the debt fund, mezzanine and preferred equity positions that accompany bridge financing, with different floating indices and daycount conventions, extension testing with notice reminders, and hedge requirements with live mark-to-market and replacement cap costs, so the position is tracked beside the senior loan it sits behind.
Frequently Asked Questions
Is preferred equity debt or equity?
Equity. It is an ownership interest in the borrowing entity with a priority return, and it holds no lien.
Who is paid first, preferred equity or the mezzanine lender?
The mezzanine lender. Every debt position in the stack is paid before any equity position, and preferred equity is paid before common equity.
Does adding preferred equity require the senior lender’s consent?
Commonly yes. Admitting the investor is a transfer of ownership interests in the borrower, and senior loan documents restrict transfers.
What happens if the preferred return is not paid?
The unpaid return accrues, and the investor’s control rights come into play: removal of the sponsor as managing member, control of the entity and the right to force a sale or refinance to recover its capital.
Why choose preferred equity over a mezzanine loan?
Because the senior lender permits one and not the other, or because the sponsor and the investor prefer an equity instrument for tax, accounting or structural reasons.
Related Terms
- Mezzanine Loan
- Subordination
- Loan-to-Value
- Covenant
- Bridge Loan
- Lender Consent Requirements: Leases, Transfers and Management Changes Your Loan Documents Control
- Loan Portfolio Management for Private Equity Real Estate Funds with Hundreds of Loans
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.
Sources
- LoanBoss CRE Debt Glossary