Bridging the Equity Gap With Preferred Equity

Steve Peterson

Rising interest rates, downward pressure on rents and fast-approaching loan maturities are combining to create a massive equity gap in commercial real estate ownership. Roughly $1.5 trillion in commercial real estate mortgages will mature over the next three years. Many property owners are struggling to raise the common equity necessary to qualify for loan extensions or new financings in an environment of decreasing property values and increased borrowing costs.

Could preferred equity, a relative newcomer to the traditional commercial property capital stack, bridge the equity gap?

Preferred equity is an equity investment with debt-like characteristics that typically receives a prescribed rate of return, a minimum return multiple (which is also a capped return), and a maturity date. In addition, preferred equity investments receive a priority return of distributions from a borrower’s income and capital proceeds.

These investments are attractive to preferred equity providers because they combine a predictable rate of return with a reduced risk of loss compared to common-equity investments. Preferred equity appeals to borrowers because the capped rate of return to the preferred investor protects the common investor’s upside and preferred equity investments (unlike mezzanine loans) are typically not prohibited by senior lenders.

One of the most appealing aspects of a preferred equity investment is the relative ease of exit. When a sponsor decides it wants to remove a preferred equity provider from its organizational structure, it only has to pay the preferred equity provider its redemption price, which is typically the amount of the original investment plus any accrued return and a redemption premium designed to ensure that the provider receives a minimum multiple on its investment. There is no need for complicated buys/sells, appraisals or loan modifications.

Potential uses of preferred equity in today’s environment are virtually unlimited, including the acquisition of interest rate caps, replenishment of required reserves, capital improvement programs, satisfaction of lender financial covenants and meeting required loan-to-value ratios.

Preferred equity investments are created in the borrower’s organizational documents. A preferred equity provider partners with the borrower (or a member of a limited liability corporation) by virtue of its capital contribution and receives the right to preferred returns in the distribution waterfalls prescribed by the borrower’s governing agreement.

In a hard pay structure, the preferred provider can exercise default remedies if the borrower fails to satisfy a minimum distribution. In a soft pay structure, the borrower is only obligated to satisfy the preferred equity provider’s return if it has available cash flow after operating expenses and debt service.

The primary default remedy for a preferred equity provider is the ability to take over control of the borrower, thus enabling it to hire a new property manager, make capital improvements, or sell the property without the consent of the removed sponsor manager.

Coming to Terms on Preferred Equity

The market for preferred equity is evolving, and its relative lack of history contributes to conflicting expectations among commercial real estate professionals over market terms.

Beyond the basic economics, the most heavily negotiated aspects of preferred equity include:

• The required redemption triggers (e.g., can the borrower refinance without redeeming the preferred equity?)
• The right of the preferred equity provider to block major decisions such as the adoption of budgets or entering into major contracts
• The default events
• The degree of latitude afforded a preferred equity provider after a takeover

Many preferred equity providers expect to have an active say in material decisions, while many borrowers expect a silent partner. Most preferred equity providers expect a robust set of default events that will allow them to take over the management of the borrower, while many borrowers expect a shorter list of triggers and more limitations on the preferred equity provider’s latitude to act unilaterally after a takeover.

To avoid encountering irreconcilable expectations too late in the transaction timeline, it’s helpful to launch any preferred equity discussions with a comprehensive term sheet that addresses some of these items.

Though potential users of preferred equity are sometimes reluctant to relinquish the control or invite the oversight that preferred equity investors expect, preferred equity providers often argue that there is always a straightforward (though sometimes expensive) exit from a relationship that has gone awry—redeem the preferred equity investor by paying the prescribed redemption amount.

Increasingly, senior lenders anticipate that preferred equity will be part of a borrower’s capital stack, and sophisticated lenders have begun to incorporate loan covenants that dictate certain aspects of a preferred equity structure, particularly the selection of hard or soft pay structures (many lenders only permit soft structures) and default triggers.

Borrowers who expect to use preferred equity should ensure that preferred equity is addressed in their senior loan term sheets or loan commitments. While borrowers and preferred equity providers once enjoyed wide latitude in structuring their investments, senior loan covenants have become significant drivers of preferred equity structures in recent years.

As the popularity of preferred equity structures increases, more preferred equity providers are entering the market. In selecting a preferred equity provider, potential borrowers should seek well-capitalized providers with experience with the property types and lender categories that match up with the borrower’s needs. Borrowers should avoid providers with reputations for predatory behavior.

Borrowers who face a refinancing risk should consider preferred equity as a potential solution to equity shortfalls. As maturity dates approach, borrowers should be soliciting not only senior loan commitments but comprehensive term sheets from reputable preferred equity providers with a track record of cooperative investing.

Steve Peterson is a partner in Alston & Bird’s Real Estate Group.