Normally, primary lenders on real estate will not loan in excess of 80% of the property’s value, and generally these first-position loans are more in the 60-70% range. Real estate owners and developers often try to increase their leverage by financing their projects with capital that is junior to the mortgage debt, but senior to the owner/developer equity. Mezzanine loans and preferred equity investments are used to achieve this higher leverage.
The growth of mezzanine loans is to some extent directly linked to the growth of commercial mortgage-backed securities (CMBS), which after a pullback following the Great Recession have returned as a primary source of commercial loan financing. In 2009, national credit rating agencies such as Standard & Poor’s and Moody’s required that CMBS offerings not include any mortgage loan that also involved subordinate mortgage debt on the property. Because of this requirement, conventional subordinate debt with a 2nd-position lien – a “junior mortgage” – was effectively eliminated as a financing option for most commercial projects.
The need for “gap” financing remained, however, and mezzanine debt – where borrowers typically pledge as collateral all of their equity interests in the underlying subsidiaries that control the underlying real property – became an attractive form of financing. Mezzanine loans are also popular with real estate sponsors/borrowers because many of these products offer accrual features that defer portions of the interest payments until the mezzanine loan reaches maturity (a “balloon” payment). These structures reduce the burden on current cash flow, and thus help the borrower’s debt coverage ratios.
The security for these loans – the sponsor’s membership interests in the title-holding entity – involves, in the event of default, a UCC foreclosure on the stock (a dependable, though somewhat involved and not super-fast, process). Once the mezzanine lender owns that stock and the associated control rights, it effectively owns the commercial project going forward.
The UCC foreclosure process is tried and true, but is a little unwieldy – involving, among other things, a “commercially reasonable sale process” that involves an auction-type marketing process. While this can be done inside of 60 days or so, it’s still a bit cumbersome and takes some time and money to orchestrate. Moreover, some 1st-postion lenders continued to express distaste toward making mortgage loans where mezzanine financing would also be in place; at a minimum, they typically seek inter-creditor agreements that clarify the rights of the two lenders.
Preferred equity arose as a way to have an automatic, self-exercising structure with direct contractual rights contained in the entity’s operating agreement. Preferred equity also avoids the need of an inter-creditor agreement with the senior lender. Preferred equity also enjoys a better position in any bankruptcy scenario, since equity positions are generally not subject to “automatic stay” or other constraints imposed by bankruptcy law.
In most other respects, preferred equity is much the same as mezzanine debt; preferred investors get a right to a special (preferred) rate of return, and the right to an accelerated repayment of capital at an agreed-upon date (similar to a maturity date for a loan). Preferred equity also lends itself to more complicated features, such as a cash distribution “waterfall” that allows the owner/developer to receive some cash flow distributions while the preferred capital is still outstanding, or even where the preferred investors “participate” in some of the project’s “upside” on top of the otherwise promised return.
While preferred investors do not usually have any foreclosure rights per se, they have specific contract remedies set forth in the entity’s operational documents in the event of a financial delinquency or a “change of control event.” In these events, the managing control of the investment entity would shift to the preferred investors, or the sponsor might be forced to sell the underlying property. Senior lender restrictions against changes of ownership often govern only changes at the lower borrower entity; if they extend to an upper investment vehicle, then sometimes the sponsor’s retention of its ownership stake will be sufficient (even though it has lost its management rights), while in other cases the preferred member will need to clarify that it will be a “qualified transferee” under the loan documentation.
Enforcing preferred equity remedies is in some respects less certain than the UCC process utilized for mezzanine loans. Litigation or arbitration as to whether a preferred equity holder’s remedies have been triggered can result in a delay in enforcement. Properly drafted preferred equity documents, then, typically demand a “bad boy” guaranty under which preferred investors have full recourse against the sponsor/borrower for any spurious challenge to the exercise of the preferred investor’s remedies.
Higher Risk, But Higher Returns
Preferred equity investments are in a 2nd position compared to the primary lender, so they are riskier than participations in a 1st-lien loan. The return rates are higher, though. RealtyShares, one of the more prominent crowdfunding sites, typically offers investors in preferred equity projects targeted return rates of 12-16%, as opposed to 8-10% on a 1st-lien business-purpose loan.
The default risk with preferred equity depends largely on the remaining equity “cushion” held by the sponsoring real estate company and the contractual protections surrounding any default. In the owner-occupied residential world, the recovery rates on defaulting 1st and 2nd debt were at one time estimated by Moody’s to be approximately 90% vs. 60%. Conventional mortgages have a very different profile than the commercial market, though; many private equity firms engaging in mezzanine debt or preferred equity investments use the change-of-control rights involved in such financings as part of their overall business plan. They have active asset managers involved in workout situations, so that their investment is salvaged and perhaps even turned around (since they now effectively control the equity upside in the project). Crowdfunding companies can be expected to follow the same model.
Preferred Equity Seems Here to Stay
Notwithstanding the post-2008 retrenchment, the past few decades in particular have witnessed a boom in the creation of structures for capital that is junior to the mortgage debt but senior to the owner / developer equity. This need actually increased post-2008 as traditional mortgage lenders tightened up their underwriting standards, leaving sponsoring real estate companies scrambling for available capital. Investors participating in crowdfunding sites like RealtyShares now have the opportunity to provide liquidity and additional capital to sponsoring real estate companies needing to fill the “financing gap” between the senior mortgage debt and the owner’s equity.