An almost 10-year period of historically low interest rates, available capital and consistent rent growth has been good to multifamily investors.

There is enough equity to go around, and for many borrowers in the middle-market space, preferred equity has become a more flexible and accessible financing vehicle. Mezzanine remains popular for larger deals or for borrowers with a significant capital investment in the property.

As interest rates continue to rise and real estate professionals anticipate higher cap rates, the choice between preferred equity and mezzanine remains an important financing decision. To Hunt Mortgage Group Managing Director Justin Short, the former remains the more attractive option for deals below $50M.

“I wouldn’t say that mezzanine is ever off the table, but we have not had to use it, especially not in the fixed-rate, stabilized space or even in the bridge lending space,” Short said. “We are still at leverage levels where folks gravitate toward preferred equity.”

A Preference For Preferred Equity

A mezzanine loan falls between equity and senior debt in the capital stack and is a hybrid of the two products. Under the terms of a mezzanine loan, financing is structured as a loan secured by a lien on the equity of the owner of the property should the borrower default on the loan. In the event of an owner default, the lender forecloses on the company that owns the property and not the property itself and follows Uniform Civil Code foreclosure proceedings. Interest rates are fixed and are at higher levels than the first mortgage.

Mezzanine financing is less expensive than pure equity and allows sponsors to obtain higher loan leverage.

Preferred equity is also an equity stake in the company that owns the real property. In return, the investors have the right to receive a fixed rate of return on their investments. It also gives investors priority over common equity shareholders in the distribution of cash flows and allows investors to bypass lengthy UCC filings in the event of foreclosure.

Mezzanine financing overall has become less common in the capital market landscape. Only 11% of the $107B in U.S. private credit funds raised last year was for mezzanine loans, compared with 33% in 2016. Borrowers are choosing preferred equity instead, as lenders issue evergreen securities that have no mandatory redemption date. Mezzanine debt generally matures in three to five years.

In the middle-market space, in which Hunt underwrites loans, increased competition among a dwindling supply of mezzanine lenders has compressed rates.

“The mezzanine that we are seeing out there is a little too rich for us,” Short said. “You are seeing mezzanine financing for larger, institutional deals trading in the mid-to-high single digits, and the smaller stuff, from $5M to $10M, it is from 10% to 11%. We have more efficient ways to get a 10% or 11% on our capital.”

Making The Case For Mezzanine

Short has seen a slowdown for mezzanine financing in the acquisition space, but bridge loans or construction financing still offer attractive mezzanine financing, depending on the type of borrower. A mezzanine loan can be an attractive way to finance minor renovations and yield modest rent growth, according to Hunt Mortgage Group Managing Director Steven Cox.

“You are eliminating interest rate risk on the first mortgage because you are fixing your rate upfront,” Cox said. “Then you can replace it with a supplemental loan in a few years when you complete the work and increase your rents or net operating income."

In secondary markets, where Class-B and C multifamily assets are more common than towering luxury high-rises, the large bump in rent expected from preferred equity investors might not be sustainable for tenants. Mezzanine loans can underwrite less significant improvements. Hunt Mortgage Group also offers mezzanine financing through Fannie Mae, which allows for mezzanine loans that are coterminous with the first mortgage loan.

Preferred equity is not for every borrower, Cox said. Investors with their own capital tied up in projects might want to avoid having an additional partner involved. Mezzanine loans limit the number of parties included in the capital stack, where preferred equity adds additional entities to the process.

“Mezzanine is safer because it is one less group to deal with, especially if you are doing the mezzanine loan with the first mortgage lender,” Cox said. “When you close the loan you are dealing with the same group.”

Consistency and simplicity of service, throughout the life of the loan, is a quality on which Hunt Mortgage Group prides itself. From mezzanine loans to preferred equity, Hunt can act as a partner with borrowers looking for first loans, mezzanine financing or preferred equity.

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