Most commercial real estate deals hit the same wall: senior debt covers 60-75% of the project cost, and the developer's equity covers 15-25%. That leaves a 10-25% gap that can make or break a transaction. Mezzanine debt and preferred equity are the two primary tools for filling that gap, but choosing the wrong one can cost hundreds of thousands of dollars in unnecessary expense, trigger senior lender defaults, or hand control of your project to a third party.
This guide breaks down every material difference between mezzanine debt and preferred equity so you can structure smarter deals and negotiate better terms.
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What Is Gap Financing and Why Does the Capital Stack Matter?
Gap financing refers to any capital that fills the space between senior debt and common equity in a commercial real estate deal. In a typical $50 million acquisition, the capital stack might look like this: the senior lender provides $32.5 million (65% LTV), the sponsor brings $10 million in equity (20%), and the remaining $7.5 million (15%) must come from somewhere else.
That "somewhere else" is gap financing, and it comes in two primary forms: mezzanine debt and preferred equity. While both serve the same purpose of reducing the amount of cash equity a sponsor must invest, their legal structures, costs, default remedies, and tax implications differ in ways that matter enormously to both the borrower and the senior lender.
The capital stack is not just a financial diagram. It is a pecking order that determines who gets paid first, who has control during distress, and who absorbs losses. Understanding where mezzanine debt and preferred equity sit in that pecking order is the foundation for every decision that follows. For a deeper look at how leverage benchmarks affect your stack, see our guide on 2026 commercial real estate LTV ratios by asset class.
How Does Mezzanine Debt Work in Commercial Real Estate?
Mezzanine debt is a loan, but it is secured differently than a traditional mortgage. Instead of placing a lien on the real property, the mezzanine lender takes a pledge of the borrowing entity's ownership interests, typically the LLC membership interests or partnership interests that own the property.
This structure gives the mezzanine lender a powerful advantage: if the borrower defaults, the lender can execute a UCC Article 9 foreclosure on the pledged interests rather than going through a judicial or non-judicial foreclosure on the property itself. A UCC foreclosure can be completed in as little as 30 to 90 days, compared to 6 to 18 months for a standard real estate foreclosure depending on the state.
Mezzanine debt sits directly behind senior debt in the capital stack. It is senior to all equity, including preferred equity. The mezzanine lender receives regular interest payments (current pay), and the loan is typically repaid in full when the property is sold or refinanced.
Common terms for mezzanine debt include:
- Interest rates of 10-15% (current pay), sometimes with additional accrual or PIK interest
- Loan terms of 2-7 years, often co-terminous with the senior debt
- Origination fees of 1-2% of the mezzanine loan amount
- Minimum loan sizes of $2-5 million for institutional providers
- An intercreditor agreement with the senior lender
Mezzanine financing is a core part of our specialty financing programs at Clearhouse Lending. We work with a network of mezzanine providers to help developers secure competitive terms.
How Does Preferred Equity Work in Commercial Real Estate?
Preferred equity is not a loan. It is an actual equity investment in the property-owning entity, structured with preferential rights that give the investor priority over the common equity holders (the sponsor/developer). The preferred equity investor receives a "preferred return" before the sponsor receives any distributions, and in many cases, the investor also receives a share of the project's profits above a certain hurdle rate.
Because preferred equity is classified as equity rather than debt, it does not require an intercreditor agreement with the senior lender. This is one of its most significant advantages. Many senior lenders, particularly banks and agency lenders (Fannie Mae, Freddie Mac), prohibit or heavily restrict additional debt behind their mortgage. Preferred equity can often be introduced without violating these restrictions because it does not technically increase the property's leverage.
The preferred equity investor's primary remedy in a default is not foreclosure. Instead, the investor typically has "step-in rights" that allow them to replace the managing member or general partner and take control of the day-to-day operations of the project. This is a slower and more collaborative remedy than UCC foreclosure, but it gives the preferred equity investor significant operational control.
Common terms for preferred equity include:
- Preferred returns of 13-20%, sometimes with a profit participation kicker of 5-15%
- Investment terms of 3-7 years, aligned with the project business plan
- No origination fees in many cases, though structuring fees of 0.5-1% are common
- Minimum investments of $1-10 million depending on the provider
- Step-in rights and management replacement provisions in the operating agreement
What Are the Key Legal Differences Between Mezzanine Debt and Preferred Equity?
The legal distinction between mezzanine debt and preferred equity is not just academic. It affects every aspect of the deal, from closing costs to default remedies to senior lender approval.
Mezzanine debt is governed by a loan agreement, promissory note, and pledge agreement. The mezzanine lender's rights are defined in these loan documents and enforced through UCC foreclosure procedures. An intercreditor agreement between the senior lender and mezzanine lender is required, and negotiating this document can take weeks and cost $25,000-$75,000 in legal fees.
Preferred equity is governed by the operating agreement (or partnership agreement) of the property-owning entity. The preferred equity investor's rights, including their preferred return, step-in rights, and exit mechanisms, are all defined within this single document. There is no separate loan agreement, no promissory note, and critically, no intercreditor agreement.
This structural difference has practical consequences. When a mezzanine default occurs, the lender can move quickly through UCC foreclosure to seize the entity. When a preferred equity trigger event occurs, the investor must work within the operating agreement's framework to assert control, which can be slower but gives both parties more room to negotiate a resolution.
How Do the Costs Compare Between Mezzanine Debt and Preferred Equity?
The headline cost of mezzanine debt (10-15%) appears lower than preferred equity (13-20%), but the true comparison is more nuanced. Mezzanine interest is tax-deductible, which reduces the effective after-tax cost. If a developer is in a 35% tax bracket, a 12% mezzanine rate has an effective after-tax cost of roughly 7.8%. Preferred equity distributions are not tax-deductible, so a 14% preferred return costs 14% on an after-tax basis.
However, preferred equity providers sometimes accept a lower base preferred return in exchange for profit participation. A deal structured with a 10% preferred return plus 10% of profits above a 15% IRR hurdle might cost less than 12% mezzanine debt if the project only modestly outperforms, but significantly more if the project is a home run.
The all-in cost comparison should also include:
- Legal fees: Mezzanine debt requires an intercreditor agreement ($25K-$75K), while preferred equity does not
- Origination fees: Mezzanine lenders typically charge 1-2%, while preferred equity providers charge 0-1%
- Exit costs: Mezzanine debt may have prepayment penalties, while preferred equity may have minimum return requirements
- Time cost: Mezzanine deals take longer to close due to intercreditor negotiation
To model how different capital structures affect your debt service, try our commercial mortgage calculator.
What Do Senior Lenders Think About Mezzanine Debt vs Preferred Equity?
Senior lender approval is often the deciding factor. Many senior lenders, especially commercial banks and agency lenders, have explicit policies that restrict or prohibit mezzanine debt. They view it as hidden leverage that increases the risk of default on their senior loan.
The concern is straightforward: mezzanine debt adds a fixed payment obligation that the property's cash flow must cover. If the property's net operating income declines, the borrower must still make both the senior debt payment and the mezzanine debt payment, increasing the probability of default.
Preferred equity, by contrast, is generally more acceptable to senior lenders because:
- It is classified as equity, not debt, so it does not increase leverage metrics
- Preferred equity distributions can be subordinated to debt service in the operating agreement
- There is no additional lien or security interest that complicates the senior lender's position
- Preferred equity investors have step-in rights rather than foreclosure rights, which is less disruptive
That said, sophisticated senior lenders increasingly scrutinize preferred equity structures. They may require that the preferred return be subordinated to debt service, that distributions be suspended during cash flow shortfalls, and that any step-in rights be subject to the senior lender's consent. Always verify your senior lender's policy before committing to either structure.
How Do Intercreditor Agreements Affect the Deal?
The intercreditor agreement (ICA) is the legal contract between the senior lender and the mezzanine lender that governs their respective rights, particularly during a default. It is one of the most heavily negotiated documents in commercial real estate finance and can take 4-8 weeks to finalize.
Key provisions in a typical ICA include:
- Standstill period: The mezzanine lender must wait a specified period (typically 60-120 days) before exercising UCC foreclosure after a default
- Cure rights: The mezzanine lender has the right (but not the obligation) to cure defaults on the senior loan
- Purchase option: The mezzanine lender can purchase the senior loan at par, stepping into the senior lender's position
- Notice requirements: The senior lender must notify the mezzanine lender of any defaults or material events
- Modification restrictions: Neither lender can modify their loan documents without the other's consent for material changes
Preferred equity structures avoid the intercreditor agreement entirely because there is no second debt layer. This saves significant time and legal expense, and it eliminates a common source of deal friction. For developers working on tight timelines, particularly in bridge loan scenarios, this speed advantage can be decisive.
What Are the Tax Implications of Each Structure?
Tax treatment is a critical and often overlooked factor when choosing between mezzanine debt and preferred equity. The differences can shift the effective cost of capital by several percentage points.
For the borrower/sponsor, mezzanine interest payments are deductible as business interest expense under IRC Section 163, subject to the Section 163(j) limitation (currently 30% of adjusted taxable income for real estate businesses that have not elected out). This deduction directly reduces taxable income and the effective cost of mezzanine capital.
Preferred equity distributions, on the other hand, are not deductible. They are treated as equity distributions from the partnership or LLC, which means the full amount of the preferred return is paid from after-tax cash flow. This makes preferred equity more expensive on an after-tax basis, all else being equal.
For the investor/lender, the tax picture is different. Mezzanine interest income is taxed as ordinary income. Preferred equity returns may be structured to include allocations of depreciation, which can shelter a portion of the return from current taxation. Some preferred equity structures also qualify for capital gains treatment on the profit participation component, which can be attractive to tax-sensitive investors.
Always consult a CPA or tax attorney when structuring gap financing, as the tax implications depend on the specific deal structure, the parties' tax situations, and applicable state law.
What Does a Real-World Deal Structure Look Like?
Consider a $30 million multifamily value-add acquisition in a major metro market. The sponsor plans to invest $3 million in renovations over 18 months, stabilize the property, and refinance or sell within 3-5 years. Here is how the capital stack might be structured with each gap financing option:
In Scenario A (mezzanine debt), the sponsor's total cash equity requirement is $6 million. The mezzanine interest is tax-deductible, reducing the effective after-tax cost. However, the deal requires an intercreditor agreement, which adds $40,000-$60,000 in legal costs and 4-6 weeks to the closing timeline.
In Scenario B (preferred equity), the sponsor's cash equity requirement is also $6 million, but the preferred equity provider may negotiate a 10% profit participation above a 15% IRR hurdle. The effective cost could be higher than mezzanine if the deal outperforms, but there is no intercreditor agreement, and the senior lender is more likely to approve the structure.
The right choice depends on the senior lender's policy, the project's risk profile, the sponsor's tax situation, and the available terms from capital providers. For construction-heavy projects, understanding how horizontal and vertical construction loans interact with gap financing is also essential.
Contact our team to discuss which structure fits your specific deal. We analyze both options side by side and present you with a clear recommendation.
What Happens to Gap Financing During Market Downturns?
Market downturns reveal the true differences between mezzanine debt and preferred equity. During the 2020 pandemic disruption and the 2022-2023 rate shock, gap financing behaved very differently depending on its structure.
Mezzanine lenders have hard contractual rights. If the borrower defaults, the mezzanine lender can foreclose through UCC proceedings regardless of market conditions. This creates urgency and can force fire sales or distressed transfers during the worst possible times. During 2022-2023, several high-profile mezzanine foreclosures resulted in significant losses for sponsors who might have recovered if given more time.
Preferred equity investors, while equally motivated to protect their capital, typically have more flexibility in their remedy. Step-in rights allow the preferred equity investor to take operational control and manage the asset through the downturn rather than forcing an immediate liquidation. This alignment of interests can preserve value for all parties in the capital stack.
However, preferred equity is not without risk in a downturn. If property values decline significantly, the preferred equity investor may find themselves in an illiquid position with limited exit options. They cannot foreclose and sell; they can only manage and wait.
How Should You Structure Your Capital Stack for Maximum Efficiency?
The optimal capital stack structure depends on five key variables:
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Senior lender policy: If your senior lender prohibits mezzanine debt, the decision is made for you. Always confirm policy in writing before spending money on legal fees.
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Project risk profile: Higher-risk projects (value-add, development, repositioning) generally pair better with preferred equity because the investor can step in to protect value. Stabilized assets with predictable cash flows pair well with mezzanine debt.
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Tax situation: If the sponsor benefits significantly from the interest deduction, mezzanine debt may be cheaper on an after-tax basis even if the headline rate is similar.
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Timeline: Mezzanine debt requires an intercreditor agreement that adds 4-8 weeks. If you are on a tight closing deadline, preferred equity can close faster.
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Cost sensitivity vs. control: Mezzanine debt usually has a lower all-in cost but gives the lender aggressive foreclosure rights. Preferred equity may cost more but offers a more collaborative default framework.
The best approach is to model both structures side by side with your actual deal numbers. Calculate the blended cost of capital, the impact on sponsor IRR, the after-tax cost, and the closing timeline for each option. Then present both options to your senior lender to confirm acceptability before committing.
Frequently Asked Questions
Can you have both mezzanine debt and preferred equity in the same deal?
Yes. In larger transactions, particularly those exceeding $100 million, it is common to stack multiple layers of gap financing. The capital stack might include senior debt, mezzanine debt, preferred equity, and common equity, each with its own cost, priority, and set of rights. However, adding more layers increases complexity, legal costs, and the time required to close. Each additional layer requires careful coordination to ensure waterfall provisions are enforceable.
Does mezzanine debt count as leverage when calculating LTV?
Yes, most senior lenders include mezzanine debt in their combined loan-to-value (CLTV) calculations. A senior loan at 65% LTV plus mezzanine debt at 15% of the capital stack results in 80% CLTV. Senior lenders typically cap CLTV at 80-85%, which limits how much mezzanine debt can be added. Preferred equity, because it is classified as equity, generally does not count toward CLTV, which is why some sponsors prefer it when maximizing leverage.
What happens to mezzanine debt during a refinance?
When the borrower refinances the senior loan, the mezzanine debt must be addressed. In most cases, the mezzanine loan is either paid off from refinance proceeds, subordinated to the new senior lender (requiring a new intercreditor agreement), or restructured as part of the new capital stack. The mezzanine lender's consent is typically required for any refinancing, and prepayment penalties or minimum return provisions may apply.
How long does it take to close mezzanine debt vs preferred equity?
Mezzanine debt typically takes 45-90 days to close because it requires an intercreditor agreement with the senior lender, which involves negotiations between three sets of attorneys (senior lender, mezzanine lender, and borrower). Preferred equity can close in 30-60 days because there is no intercreditor agreement. The operating agreement amendments needed for preferred equity are simpler to negotiate, especially when the senior lender does not need to consent to the equity structure.
Is preferred equity truly equity, or is it disguised debt?
This is one of the most debated questions in commercial real estate finance. The IRS, bankruptcy courts, and senior lenders each have their own tests for distinguishing true equity from recharacterized debt. Key factors include whether the preferred equity investor shares in the property's upside and downside, whether the return is fixed or contingent, and whether the investor has remedies that resemble foreclosure. If a preferred equity investment looks too much like a loan (fixed return, guaranteed repayment, lien-like security), it may be recharacterized as debt, which could trigger senior loan defaults and adverse tax consequences. Careful structuring with experienced counsel is critical.