A preferred equity investment provides a sponsor with the ability to supplement the capital stack. When thinking about options for equity, preferred equity creates many advantages.
Reduce Common Equity Requirement
Consider an investor who typically raises equity capital in the $7-8 million on an individual deal.
An opportunity to purchase a $50 million apartment is available. Typically, the investor would pass on this opportunity because the check size would be close to $15 million on using a 70% LTV senior loan.
With a preferred equity position to cover half of the total equity ($8.0 million), the investor would be would be able to raise the additional equity ($7.0 million).
In essence, the investor now has the opportunity to chase larger transactions while not over-stressing its current equity base.
Increase Upside Potential
Typically, a preferred equity investment is capped with a fixed rate of return.
Consider a deal that achieves an IRR of 16% using only common equity. If preferred equity with a fixed return of 11% is contributed as half of the total equity in the deal, then the common equity stands to make 21% as opposed to the original 16%.
The lower cost of capital for the preferred equity position provides additional upside for the deal simply through its structure.
Take Advantage of Loan Assumptions
Consider the $50 million apartment deal discussed earlier.
Now, instead of acquiring fresh debt, the property has an existing loan in place. The leverage is 60%, whereas the market would size the senior loan to 70%.
In this scenario, the investor is dealing with a $2 million defeasance cost in order to payoff the existing loan. A preferred equity investment could be contributed to cover the 10% gap (or more depending on the particular need), which would avoid the defeasance cost.
The additional proceeds would serve as the additional supplement to make the deal work without having to pay the defeasance cost.
Meet Tight Timelines
Once a deal is signed up, the time between the execution of a PSA and the closing date can come quickly. In some cases, the interim deadlines come with hard deposits, making the need for securing financing that much greater.
Generally, a preferred equity investor can move more quickly than a larger common investor in making a decision being that the preferred equity investor is not necessarily tied to the many variables that influence a common investor’s decision to invest.
Recapitalize an Investment
Similar to filling in the gaps left from the initial financing from a low LTV loan from a senior lender, preferred equity allows sponsors the opportunity to ‘reorganize’ the existing financing. Examples of reasons to augment the capital stack include:
- Creating a Liquidity Event
- Financing Capital Expenditure
- Reduce Senior Loan Fees
Using preferred equity also helps to avoid changing the common investor profile, which keeps the old deal active while providing capital for planned use.
Exercise a Partner Buyout
In some cases, a large investor may want to exit a deal. The most common situation for this is in a development/ground up transaction, where the development is complete and stabilized.
Generally, the large investor is seeking development returns from a successful build and is looking to get out of a deal to achieve those returns. Post-development, the yield on the investment typically trails off as time goes on.
In these cases, the sponsorship may have built up sufficient equity to buyout an existing partner with a preferred equity investment and may not want to exit the deal. The new preferred equity dollars provide a liquidation preference for the large investor and allow the sponsorship an opportunity to keep the property while maintaining control.
Improve Exit Optionality
One of the biggest advantages to preferred equity is the added flexibility that it offers when compared to other forms of financing, such as a bridge loan. A bridge loan can be a good solution for financing a transitional asset, but it typically has a short term.
The biggest downside of a short-term deal is the exit risk due to a capital markets shift or a business plan that may not achieve its full potential during the term of the bridge loan.
Preferred equity, on the other hand, gives the sponsor more options. In today’s market, a traditional senior loan with a preferred equity position offers a capital stack with a very similar total cost of capital to a bridge loan with one added benefit, the senior loan and preferred equity position have a long-term horizon.
The long-term horizon provides additional cushion for business plans and also offers the sponsor optionality for an exit early in the deal or out to the senior loan maturity (which can be 7 to 10 years out, or longer in some cases)
Create a Transitional Bridge
The value-add and transitional assets typically provide a higher yielding asset. The drawback of these deals is that traditional senior loan proceeds are sized to current cash flows.
One creative structure for getting the most capped proceeds out of this type of deal is bridging the business plan with a preferred equity investment. The preferred equity investment increases equity dollars to the deal and reduce the common equity requirement.
Once the plan is completed a few years down the road, the preferred equity can be paid off using supplemental loan proceeds offered by the agencies. The preferred equity is ultimately traded for the reduced cost of capital from the supplemental loan (usually with a 10-year term).
The long-term nature of this investment provides the best opportunity for reduced cost of capital while still maintaining flexibility on exit.