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Preferred Equity – A Timely Strategy
September 8, 2020
These current uncertain times have been an opportunity to reevaluate the market and assess where the best risk-adjusted returns can be achieved throughout the commercial real estate sector. One interesting development in the market is the credit markets dislocation caused by COVID-19. Due to various reasons, many lenders have either been sidelined or have reduced their loan amounts, causing a gap in the multifamily capital stack. Additionally, lenders, including Fannie Mae and Freddie Mac are now requiring reserves which are held back from being funded at closing, further exacerbating the aforementioned gap.
Nevertheless, sponsors are still eager to acquire new deals as well as recapitalize existing properties in their portfolio to take advantage of the extremely low interest rate environment. Preferred equity is a great solution to meet the needs of transactions in this new environment. Preferred equity is an equity investment given priority distributions as well as a priority on return of capital, only subordinate to the senior lender. Due to this subordination of the common equity, often a fixed rate of return, and default remedies/control rights, preferred equity has many characteristics of a debt investment but has the higher returns and tax benefits of an equity investment in a typical multifamily syndication.
The concept of preferred equity is similar to class A shares in a dual-tranche syndication structure which have downside protection and a fixed rate of return. However, true preferred equity is superior to investing in a class A tranche of a syndication because not only are the returns higher, a 3rd party preferred equity position provides much better protection through control rights and default remedies. For example, a preferred equity investment is usually accompanied by the ability to take over management and dilute the common equity in the deal in order to ensure the preferred equity’s objective returns are still met, even in a downside scenario.
So, what does an example look like? Let’s take a $10,000,000 investment and assume the sponsor would normally receive a 75% loan-to-value (LTV) loan from a senior lender, but because of the current market environment, the lender is only willing to lend at 70% LTV. The equity requirement then is $3,000,000. However, the sponsor would prefer to raise/invest as little equity as possible and maximize his or her returns and therefore pursues a preferred equity investment. The preferred equity investor is willing to invest up to 85% LTV, which is an additional $1,500,000 on top of the loan provided by the senior lender. This means the preferred equity position has 15% of equity cushion which is subordinate to it and in a first-loss position. If the property lost 10% of its value, the preferred equity investment would still be fully protected and still have some equity cushion remaining. In exchange for providing the $1,500,000, the preferred equity investor will receive 8% cash flow, paid on a monthly basis as well as accrue an additional 6% to be paid upon a refinance or sale. In total, the preferred equity position is targeting to receive a 14% annualized return with great downside protection. Meanwhile, the remaining/common equity receives all of the upside after paying the preferred equity it’s fixed rate of return.
In today’s market of high prices and great uncertainty, a preferred equity strategy like this is highly attractive to savvy investors who are willing to trade potential upside for downside protection and a greater certainty of achieving stated returns, all while receiving great tax benefits just like a traditional equity investment.