Filling the Gap Through a Preferred Equity Strategy

By Jay Maddox, Principal, Avison Young: When to prefer preferred equity?

Preferred equity financing for commercial real estate projects has become pervasive, as owners and developers have increasingly relied on alternative capital sources to complete mission-critical transactions. Preferred equity is available from a wide variety of sources for most any situation including acquisitions, development, construction, and refinancing of underwater maturing loans. It typically plugs the gap in the capital stack between senior debt and common equity (i.e. the next 15 percent to 20 percent or so of value on top of a 60 percent to 70 percent first mortgage loan).James Maddox

When to Prefer Preferred Equity

Preferred equity is especially attractive when a project cannot support additional debt and the developer/owner needs more funding. Many senior lenders will not permit subordinated or mezzanine debt because of the increased default risk. If subordinated and mezzanine debt is permitted, the documentation can be very complex because of inter-creditor rights and remedies. With that said, preferred equity is usually less complicated to document than mezzanine debt.

How Preferred Equity Works

Preferred equity is typically structured in a debt-like manner. The investor receives a fixed return over a specified time period that is paid out of available cash flow after senior debt service and prior to common equity distributions. The total return can be anywhere from 8 percent to 20 percent today, depending upon project risks. Typically, a portion is paid current from available cash flow (or from a reserve established at funding), with the balance of the preferred return deferred and paid at the back end. The preferred equity investment together with the deferred return is required to be repaid by a certain date called the mandatory redemption date. Most preferred equity investors are IRR driven and therefore favor shorter term instruments of three to five years. Although this is equity, the fixed distributions may be deductible (similar to mortgage interest) for income tax purposes in certain cases.

Additionally:

  • While the developer/owner maintains day-to-day operating control, preferred investors usually have veto rights over major property finance and ownership decisions.
  • The deal may include performance milestones that, if not met by the developer/owner, can result in substantial ownership dilution or potential loss of control of the property.
  • The preferred investor seldom, if ever, provides financial support for senior loan guaranties, and has no obligation to contribute additional capital in the event of shortfalls.
  • Senior lenders:
    • Will generally treat preferred equity as part of the sponsor’s total equity contribution, since it is not a lien on the property.
    • Some have tightened their loan documents and underwriting standards to limit the potential risks presented of a preferred equity structure.

Completing the “Hat Trick”

Because of the need to address potential senior lender concerns, it is very important to provide a clear picture of the preferred equity structure and identity of the investor that is being contemplated early in the transaction process. A preferred equity investor will need to clearly understand the pricing and structure of the senior loan to ensure that the project can support its required returns and fits its risk profile. The developer/owner’s equity partners will also have similar concerns. So, the developer/owner has to complete a “hat trick” of sorts, bringing all of the project debt and equity players into alignment.  And, to make matters more challenging, there is no one size that fits all preferred equity structure.

While this type of investment has become pervasive, it is a cottage industry comprised of many different investors both large and small. Consequently, many developer/owners are turning to sophisticated third-party intermediaries who have a deep knowledge of the market to both source and structure these potentially valuable financing instruments.

This is Part 1 of a two-part series featuring insights on how to “fill the gap” between a senior mortgage loan and borrower equity. Part 2, “Filling the Gap Through Mezzanine Financing,” appears in the Dec. 2 newsletter edition.