Raising millions of dollars in capital for the purchase, renovation or development of commercial real estate is no easy task.
Sometimes, senior debt through traditional lending is not enough. For example, your bank may cap you at 65% loan-to-value. Your bank also may prohibit you from taking a second mortgage.
In this situation, you are left with a shortfall. For instance, you may need a total of $10 million for your project, but your bank is conservative and will only provide you with $6.5 million. You can put down $1 million from your own funds, but how will you find the remaining $2.5 million? Because your bank will not allow subordinate or mezzanine mortgage loans to be placed on the property, taking out more debt from another bank is not an option.
The solution may be a preferred equity investment. It can serve as the gap funding to complete your capital stack and achieve the full leverage you need.
What is the capital stack?
First and foremost, before diving into the realm of preferred equity, what is a “capital stack”? Think of a capital stack as a tower of building blocks, with each building block representing a source of capital for funding the real estate project at hand.
There are four main types of building blocks in a capital stack: (1) common equity; (2) preferred equity; (3) mezzanine debt; and (4) senior debt.
Visually, the capital stack looks like this:
The capital stack depicts the different risk levels and rates of return for each category.
Here’s how to navigate the capital stack:
- Risk increases as you move higher in the capital stack.
- Likewise, returns increase as you move higher in the capital stack.
- Upon sale or refinance, the bottom tier gets paid first until fully repaid and so on.
- To the extent there are insufficient funds to fully repay all the capital, the losses are incurred from the top down.
Sitting at the top of the capital stack is common equity, which has the highest risk and highest rate of return. Common equity holders have the riskiest position because they are paid last. Real estate developers and investors, often referred to as the sponsors, are typically the ones who contribute this type of equity as co-investments. Common equity is also held by the founders and employees of the company.
The next level down on the capital stack is preferred equity, which will be the focus of this article. As with common equity, preferred equity entails an ownership interest in the company. However, in the pecking order, preferred equity is senior to all common equity, but subordinate to all debt — mezzanine and senior.
Aptly named for sitting between the ground and first floors of the capital stack, mezzanine debt sits between preferred equity and senior debt. Like preferred equity, mezzanine debt serves as gap funding to provide additional leverage. Unlike preferred equity, mezzanine debt is generally structured as a loan that is secured by a lien on the property.
Finally, serving as the foundation at the bottom of the capital stack is senior debt, which has the lowest risk and lowest rate of return. Senior debtholders (typically, banks and other traditional lenders that provide mortgage loans) enjoy seniority to everyone above them in the stack. Their interest is secured by a first mortgage lien on the property.
As alluded to above, senior debtholders oftentimes restrict the borrower from obtaining subordinate or junior debt. As such, the mezzanine debt building block is off-limits. This is where preferred equity can come in to save the day and provide the necessary gap funding.
What is preferred equity?
Preferred equity investments are oftentimes the least understood slice of the capital stack. The confusion stems from the fact that there are many preferred equity structures falling on a wide spectrum.
On one end of the spectrum, some preferred equity arrangements are “hard” and function much like mezzanine loans (without actually being a loan).
On the other end of the continuum, other preferred equity arrangements are “soft” and are closer in nature to true equity.
Generally speaking, regardless of where the structure falls on the spectrum, here are typical traits of preferred equity investments in commercial real estate:
How is preferred equity documented?
The preferred equity investor and the sponsor are joint venture partners. Therefore, rather than a loan agreement, the relationship is documented through a corporate document, such as a limited liability company (LLC) or limited partnership (LP) agreement.
- Who manages the day-to-day affairs? The sponsor manages the daily activities of the endeavor, but often subject to the preferred equity investor’s approval for major decisions.
- How is repayment done? Under “hard” arrangements, the sponsor must repay the preferred equity investor with monthly interest payments, irrespective of cash flow, much like a loan. Alternatively, under “soft” arrangements, the sponsor does not have to make set payments, but rather is required to pay only when there is sufficient excess cash flow.
- What are the default remedies? If the sponsor defaults, the preferred equity investor’s remedies may include the right to remove the sponsor from control of the joint venture and become managing member going forward.
Is there an end date?
There will usually be a mandatory redemption date at which point the equity investment must be redeemed in full. Sometimes, the redemption date will coincide with the mortgage loan maturity date of the senior debt. Or, the preferred equity structure may have a much shorter duration of one to two years.
How do I know if preferred equity is the right solution for me?
Here are the pros and cons of preferred equity to weigh:
- It is relatively easier (and sometimes, it is your only option) to obtain your mortgage lender’s consent to preferred equity (as opposed to mezzanine lending).
- Depending on the structure of the preferred equity, there may be no fixed payments.
You can continue to operate within your business plan and budget without too much interference from the preferred equity investor.
The preferred equity investor can have veto power over major operational decisions.
- Upon default, the preferred equity investor can exercise the right to force a sale or become managing member going forward.
The costs to obtain preferred equity may be higher than mezzanine and senior debt.
In short, the beauty of preferred equity lies in its flexibility. You can negotiate your ideal place on the spectrum between the “hard” debt-like varieties and the “soft” equity-like varieties, all without running afoul of your senior debtholder’s prohibitions against taking out more debt.
Also, it is possible to be creative with preferred equity. For example, no real estate? No problem. Some preferred equity investors do not even require commercial real estate, and will instead look at the company’s other assets, such as accounts receivable, equipment, or inventory.
Finding the right potential preferred equity investor can be daunting, but not impossible. Preferred equity investors can be high net worth individuals, specialized wealth-management firms, or other types of developers or investors who seek equity-like rewards with less risk than common equity.
For example, we can connect you to preferred equity investors who typically offer at least $3 million at a two-year repayment schedule with a monthly interest rate equal to the one-year constant maturity treasury rate (CMT) plus an approximate markup of 2 percent.
Contact us today to start exploring whether preferred equity would be the right fit for rounding out your capital stack and getting your project underway.
Continue exploring our “Beyond Banks” series:
To access all the volumes in this series, go to our “Series” page here.