by Charley Babb
We were recently engaged by clients to help monetize some of their trapped equity in an appreciating asset on which they had placed securitized debt three years ago. The current senior debt is in an amount equivalent to 50% of the asset’s value. As is the case with most securitized debt, secondary debt placements are prohibited by the loan documents. In addition, they did not want to give up any of the future appreciation through a traditional sale of a minority interest in the equity of the property. It seemed to all that the obvious solution would be to arrange preferred equity for the asset to convert some of the balance sheet equity to cash.
There was plenty of cash flow to service the preferred return on such an investment, and it seemed that all that the sponsor would have to do would be to subordinate the cash flow to the new investor in order to attract the capital. This would be a fairly straightforward assignment, right? WRONG! After soliciting over sixty capital sources with what was clearly marked as a preferred equity request, we had multiple offers for what we thought was preferred equity. Good so far. It turns out, however, that everyone seems to have a different definition for preferred equity.
My presumption was that preferred equity in a real estate investment would perform much the same as owning a share of preferred stock in a corporation. The priority of cash flow after operations is relatively clear: first to the lenders and/or bond holders, second to the preferred stockholders, and finally to the common stockholders. Thus, the net operating income of our client’s property would first be distributed to the servicer for the securitized debt holders, second to the preferred equity investor, and finally to our client. Should future cash flow diminish, our client would be the first to see their returns decrease or even be eliminated if times got tough.
If performance really suffered, I assumed that, as with preferred stock, the preferred equity coupon would accrue until it could be paid currently before our client would see a dime. But, more importantly, there would be no call on repayment or triggering of loss of control by the sponsor. That, it turns out, is not the case with the so-called preferred equity providers who were interested in pursuing our transaction.
It is important to note that, at present, there is an abundance of mezzanine debt financing available for commercial real estate assets. As such, many of the capital sources that we approached are in the mezzanine finance business but also offer a preferred equity option as well. The catch is that their perception of the difference between the two is primarily the presence or absence of a recorded lien. They still want all of the bells and whistles with regard to recognition, notice, control rights, etc. that they would have garnered by placing a mezzanine loan on the property. The trouble with that is, as mentioned earlier, the first lien lender prohibits all of those benefits.
In our search we also came across an investor whose concept of preferred equity not only included a priority on distributions, but true equity participation in the upside of the value of the property. The net result of our efforts was that most investors priced their money at 10 to12%, which is acting like a preferred equity provider but requiring mezzanine lender recognition and control rights.
Ultimately, we found a few providers that were willing to accept true preferred equity status (as defined above), but the cost of the money moved into the 13% to 15% range, almost 300 basis points above the pricing of mezzanine lenders. Thus, the price of risk is clearly differentiated by how a provider is willing to characterize and protect its investment. I suppose the lesson learned here is, “the beauty of preferred equity is in the eye of the investor.”
To help you analyze your options for mezzanine, preferred equity or any other type of commercial real estate financing, contact me, Charley Babb, email@example.com, or visit our website, www.metcapital.com. Charley Babb is a Senior Director and a principal in the Metropolitan Capital Advisors Denver, Colorado office.