Preferred equity becomes the preferred lifeline

The structure is becoming the place more lenders want to be in the capital stack.

Preferred equity, long an important component of a commercial real estate capital stack, is becoming the structure of choice for many lenders seeking to originate financings that bridge the gap between a senior loan and sponsor equity.

While mezzanine debt also can be used to plug this gap, market participants who spoke to Real Estate Capital USA outlined what they believe are advantages of the preferred equity structure. The main one is its position in the senior portion of the capital stack, which provides additional protection for lenders, says Marcus Duley, chief investment officer at Denver-based Walker & Dunlop Investment Partners.

Walker & Dunlop, which can make both preferred equity and mezzanine debt investments, sees a specific area of opportunity in the former as an investor. “It is a good risk-adjusted return to invest lower in the capital stack with an equity cushion and still have attractive returns and yields – particularly in an environment where there’s still price discovery and uncertainty around valuations,” Duley says.

Mind the gap

The need for gap financing began last year, when the US Federal Reserve and other central banks began raising interest rates to combat inflation, and intensified as the broader macroeconomic environment became more fraught. Higher interest rates, volatility in the banking sector and geopolitical turmoil meant that senior lenders were offering lower proceeds on acquisitions and refinancings, market participants told Real Estate Capital USA.

“In this situation, the borrower needs to come up with additional equity to fill that gap, which is either not attractive to some borrowers, or, quite frankly, just not available,” says Diana Brummer, partner and co-chair of real estate industry at New York-based law firm, Goodwin. “[Firms] do not have a capital source for an additional equity infusion. This is where we are going to see an increase, or we are already seeing an increase, in preferred equity.”

Rich Ortiz, co-founder and managing principal at New York-based management firm Hudson Realty Capital, says the firm has been tracking this issue for roughly 18 months. Ortiz cited an example of a stabilized, multifamily building, which in the past would be underwritten to a 75 percent loan to value. But first mortgages simply are not providing the same proceeds as in the past.

“That same loan is being underwritten at 60 to 65 percent, or somewhere about 20 to 25 percent less, simply because it’s a higher interest rate environment. So that shortfall, that gap, is what you’re seeing that is creating the demand for equity,” Ortiz says. “Hopefully in three to five years, [the sponsor will] be able to go back out to the market and refinance at a higher level and pay back the preferred equity.”

The phenomenon varies by sector. Due to large, expected value declines, the office sector has the largest financing gap by far at approximately $28.5 billion, according to research published earlier this year by Dallas-based advisory CBRE. Retail is next in line at $1.8 billion. But, due to significant value appreciation, the industrial and multifamily sectors have negative financing gaps, the report found.

Rising competition

As the financing gap has unfolded, Real Estate Capital USA has tracked several targeted funds or platforms that are being raised, including a $100 million initiative launched by Los Angeles-based merchant bank Dekel Capital in June. Boston-based manager Taurus Investment Holdings rolled out a similar platform earlier this year.

The increase in providers has meant there has been competition for the highest-quality deals. Additionally, the percentage of the capital stack that preferred equity comprises has been rising, says Hen Shoval, director of investments at Miami-based investment manager Pensam.

In May, Freddie Mac and Pensam funded a $220 million recapitalization of a 631-unit multifamily complex in Doral, Florida. Pensam funded the $65.8 million in preferred equity, while Freddie Mac funded the remaining $154.1 million. The preferred equity component makes up about 32 percent of the deal, which is noteworthy for a transaction of this scale. Pensam, which has long been an originator of this type of financing, expects to see more deals like this in the near-term, Shoval says.

Looking ahead

Walker & Dunlop’s Duley believes the need for preferred equity and mezzanine debt will be sustained, both for refinancings and new loans. There are also situations in which a sponsor may have to put in additional capital during the life of a loan if declines in valuations breach LTVs and trigger a cash trap or a default, he adds.

Sponsors, like lenders, favor preferred equity, albeit for slightly different reasons. The structure is cheaper than common equity – although more expensive than a first mortgage loan.

“Your total cost of capital means it still can be reasonable and hit your targeted returns,” Duley says. “If you are looking at loan maturity, and you are faced with the prospect of refinancing and not having enough cash, preferred equity is going to be less dilutive.”

There is one other part of the commercial real estate capital markets that has seen substantial interest from lenders and borrowers, says Jeffrey Beckham, executive vice-president and head of portfolio management at Alabama-based investment firm GID Capital. 

“[Preferred equity] and bridge lending is getting a lot of interest,” Beckham says. “There are a lot of gap products that are trying to help people get to a point where hopefully interest rates come down and there is more liquidity. But none of them are great [and] they all come with very expensive price tags.”

Still, it remains a good time to be a preferred equity provider, says Beckham. “If you’re on the side that you can provide that kind of assistance or type of product, then it’s a great time – if you’re on the other end, you don’t have many options.”