Mezzanine Debt, Preferred Equity, and B-Notes

Introduction

Between the senior mortgage and the sponsor's common equity sits a layer of subordinate capital, and it does one job: it adds leverage above what the senior lender will provide, letting a sponsor finance more of a deal with less of its own money. That layer comes in three forms that look almost interchangeable in a capital-stack diagram but differ entirely in legal structure and, when a deal goes wrong, in what the holder can actually do. Mezzanine debt is a loan secured by the ownership interests in the property. Preferred equity is an equity investment with priority over common. A B-note is the junior slice of a single mortgage. The distinctions sound technical, but they determine who controls the asset in a default, how fast a holder can act, and how the position is priced, with preferred equity typically yielding 100 to 200 basis points more than mezzanine on the same deal.

The capital stack for a leveraged property runs from the senior mortgage at the bottom, which is repaid first and bears the least risk, up through subordinate debt and equity to the sponsor's common equity at the top, which is paid last and bears the most. Subordinate instruments fill the gap between a conservative senior loan and the common equity, and a sponsor reaches for them when the senior lender will only go to, say, 60% of value but the sponsor wants total leverage closer to 80%. That extra slice is cheaper than common equity and avoids diluting the sponsor's upside, which is why it is so widely used.

The three instruments occupy nearly the same position in the stack but are built differently, and the differences are best seen side by side.

The return these positions earn is structured to sit above the property-level cash flows that common equity lives on, which is why the IRR, equity multiple, and waterfall mechanics that govern common returns also frame how subordinate capital gets paid. Within the broader CRE debt universe, this is where debt funds and other non-bank lenders earn their highest yields.

Mezzanine debt is the most loan-like of the three. It is a true loan with contractual interest, but it is not secured by a mortgage on the building. Instead it is secured by a pledge of the borrower's ownership interest in the entity that owns the property, which has a profound effect on what happens in a default.

Mezzanine debt

A loan that sits behind the senior mortgage in the capital stack, secured not by a lien on the real estate but by a pledge of the equity interests in the property-owning entity. On default, the mezzanine lender forecloses on those ownership interests, taking control of the entity (and thus the property) rather than the real estate directly.

The UCC foreclosure advantage

Because the collateral is an equity pledge rather than real estate, a mezzanine lender forecloses under Article 9 of the Uniform Commercial Code rather than through real property law. The difference is speed: a UCC foreclosure can be completed in as little as 10 days and typically runs 45 to 90 days, against the many months or years a judicial real estate foreclosure can take. The mezzanine lender ends up owning the entity that holds the property, stepping into the sponsor's shoes above the still-intact senior mortgage. That fast, clean remedy is exactly why mezzanine debt prices tighter than preferred equity: the holder has real teeth.

Preferred equity sits one notch riskier. It is not a loan at all but an equity investment in the property-owning entity, entitling the holder to priority distributions ahead of the common equity but behind every debt obligation.

Preferred equity

An equity investment in the entity that owns or controls a property, carrying a fixed priority return (commonly 10% to 15%) that must be paid before common equity receives any distribution. It ranks below all debt and, unlike mezzanine debt, has no collateral to foreclose on, so its remedies on default are contractual rather than possessory.

The crucial weakness is the absence of a foreclosure right. A preferred equity holder cannot seize collateral, because it holds none; its remedies are contractual and depend on the documents and, often, on litigation or sponsor cooperation. Typical remedies include the right to force a sale of the asset, remove the sponsor as managing member, accrue a penalty rate, or trigger a buyout, but each is slower and less certain than a mezzanine lender's UCC foreclosure.

A B-note is the third route into the subordinate layer, and it works differently again. Rather than a separate loan or equity piece, a B-note is created by splitting a single mortgage into a senior A-note and a junior B-note. Both are secured by the same mortgage on the same property; the B-note simply agrees to be paid after, and absorb losses before, the A-note. The risk and return are similar to mezzanine debt, but the control features differ because everything is governed within one loan rather than across separate instruments.

Whether the subordinate piece is mezzanine debt or a B-note, the relationship with the senior lender is governed by an intercreditor agreement, and negotiating it is often the most complex part of the deal. The senior lender must approve the subordinate financing in the first place, and the agreement sets out exactly how the two lenders coexist.

The purchase option is the most powerful provision. If the senior loan goes into default, the mezzanine or B-note holder can often buy it out at par, the outstanding balance plus accrued interest and fees, taking control of the entire debt stack rather than watching its junior position get wiped out in a senior foreclosure. The B-note and A/B structure is closely related to the tranching logic of CMBS, where subordinate classes play the same role inside a securitization.