3650 REIT preferred equity financing illuminates shift in capital stack

A preferred equity position originated by 3650 REIT illustrates how this type of financing is allowing acquisition loans and refinancings to move ahead.

The national lender made a preferred equity investment in a $500 million Sun Belt apartment portfolio acquisition on behalf of RREAF Holdings and DLP Capital at the end of October. Equity capital was provided by the three portfolio partners, with Freddie Mac providing debt financing through New York-based commercial real estate bank Berkadia.

“Preferred equity investments, like bridge debt, tend to find favor in markets where traditional equity investors are skittish about values and are inclined to accept lower returns in exchange for lower risk,” says Jonathan Roth, 3650 REIT’s co-founder and managing partner. “Whatever the change, the debt markets are not as liquid as they were and there may be situations where sponsors need some cash to help support their deals.”

Equity by name, debt by nature

Preferred is distinct from mezzanine debt, although it often serves the same purpose in the capital stack. Unlike mezzanine debt, which is secured by a sponsor’s equity position in a deal, preferred has higher priority for distributions than common equity.

Diana Brummer, partner and co-chair of the real estate industry division at New York-based law firm Goodwin, is witnessing a rise in preferred equity activity. “The economic terms for preferred equity are much more debt-like [because] the preferred equity investor would get paid earlier than the common equity investor but with a capped return,” Brummer says. “If you give debt investors the choice between a mezzanine loan and preferred equity, you’ll find some would actually rather go the preferred equity route.”

Another consideration with preferred equity is, unlike mezzanine debt, there is no need to exercise foreclosure remedies in a distressed situation. Finally, preferred equity may be considered equity or debt depending on the tax purposes.

“Preferred equity investments, like bridge debt, tend to find favor in markets where traditional equity investors are skittish about values”

Jonathan Roth, 3650 REIT

“The request for a debt group to consider preferred equity is most frequently based on feedback from the senior lender,” Brummer adds. “You would [choose] to do a preferred equity investment instead of a mezzanine loan if the senior lender prohibits mezz behind it.”

Robin Potts, Canyon Property Partners’ co-head of real estate investments, describes preferred equity as analogous to subordinate debt, given it can be structured to make full return of capital a priority, Potts says. “But also, [there are] just overall structuring elements that are consistent with how a mezzanine loan might be structured,” she adds.

Often preferred equity would be a fully accruing coupon, explains Potts, whereas a mezzanine loan would typically be a full current pay coupon.

“In certain instances, preferred equity may have a profit participation component,” she adds. “There are some differences in terms of how they may be structured, but it is a subordinate debt solution. And in many cases, it is driven by the senior lender and their willingness to have a mezzanine loan structure behind them or not.”

3650 REIT’s Roth believes even preferred equity investments can be challenging in an increasing interest rate environment or a market where values are declining.

“Both of which may be the case today,” he stresses. “As a result, we expect the volume of preferred equity investments supporting new acquisitions to decline over the coming months, although that may be offset by an increase in volume for transaction recapitalizations.”