Using a preferred equity structure in a multifamily deal has many similarities to a deal without preferred equity. Understanding the key distinctions and requirements when including preferred equity helps the overall diligence and closing process run smoothly.
Understand the Timeline
Similar to most institutional equity and senior mortgage lenders, most institutional preferred equity performs due diligence relating to the property and deal economics. This process, beginning with underwriting and ending with closing, typically takes around 4-6 weeks.
The earlier a sponsor brings in the preferred equity investor, the less likely it is that there will be holdups. Giving the senior lender time to run due diligence on the preferred equity investor and organizational structure as well as giving the preferred equity investor time to complete its own diligence process is key to a smooth closing.
Negotiate a Detailed Term Sheet
Preferred equity is not as standardized a structure as a senior mortgage loan. The terms are more analogous to a joint venture equity arrangement. There are nuances to each preferred equity investor’s platform that could potentially lead to unnecessary or even detrimental situations because the deal is not spelled out well in the early negotiations.
Aside from general economic terms, preferred equity may have covenants that are completely unique in the preferred equity market and should be understood fairly early in the process.
Though covenants often mirror a senior mortgage lender’s requirements, such as property insurance covenants, there are bound to be some items that are not found in senior mortgage loan documentation, similar to other equity ventures. Exceptions can include covenants relating to entering into leases, violations of the senior loan documents, management of the property-operating entity, reporting standards, major decisions, or, most importantly, economic/performance hurdles.
Generally, reporting requirements and details relating to control are going to be similar to equity arrangements and thus more stringent that what would be found senior mortgage loan documents. It is better to have these items discussed early in the negotiation stage as opposed to the closing table.
Look Out for Long Lead Times
Preferred equity investor diligence items often mirror many components of senior mortgage lenders, creating useful overlap. Some items that may have additional preferred equity requirements beyond senior lender requirements can include:
Most preferred equity requires third-party reports. An efficient and cost-saving method for a sponsor is ensuring, to the extent possible, that the preferred equity investor uses the same reports. In most cases, there are ways to piggyback off of the senior mortgage requirements, thus reducing time and cost to the sponsor. These reports can include appraisals, engineering and environmental reports, zoning reports, and background reports.
Note that there are also cases when the senior lender may not require third-party reports; a good example is during a loan assumption (though not always the case). A sponsor should ensure that the preferred equity investor does not need third-party reports above and beyond what is required by the senior mortgage lender.
For situations where the senior lender does not order new reports, the preferred equity investor may choose to order any or all of these reports. Such reports typically have a 2-3 week lead time, so sponsors should quickly determine whether the senior lender will order the third-party reports and inform the preferred equity investor as early as possible to cut down the chance of delays.
Background checks on individuals and entities identified during underwriting may also differ. A preferred equity investor may have different requirements and often will order its own background checks. Supplying a draft organizational chart at the beginning of due diligence can minimize the possibility of holdups in this area.
Proposed Organization Documents
A proposed organizational chart is a helpful tool for determining structure for the deal, including identifying guarantors and entities or individuals with control rights.
For entities and individuals identified in the organizational chart as having significant control rights, preferred equity investors may collect operating agreements or other organizational documents, financials, property management company resumes, and certificates of formation and good standing.
When an acquisition of a multifamily property requires a complicated equity structure, such as a 1031 exchange, there may be delays on either the buyer’s side or the seller’s side, and having a proposed org chart toward the beginning of the process will help the preferred equity investor determine whether a more complicated equity structure will be in play.
Other complicated org structures such as multiple Tenants-in-Common (TICs) can also require extra diligence which could create holdups if the structure is not agreed upon and approved by the senior lender early in the due diligence period.
Capital and Operating Budgets
An operating budget and, if applicable, a capital budget are integral parts of the business plan in most preferred equity deals. During the due diligence phase, these budgets should be finalized, and the preferred equity investor may require that an approved version be included in the final governing documents. These budgets generally require additional detail that may not be required by senior mortgage lenders.
Finalizing these budgets as early as possible in the process reduces the risk of having to re-underwrite a deal to account for a material change to the operating or capital budget. Since the deal structure may need to be altered to account for such changes, which could take time to negotiate, sponsors will want to avoid having this happen in the late stages of the diligence process.
This diligence includes trailing financials, rent rolls, and insurance certificates, for example. Many of these items are also required by senior mortgage lenders so should not create additional burden for sponsors to provide.
The key to avoiding potential holdups in this area is for the sponsor to make sure that these items as they become available so that the closing process is not delayed due to a missing document. There may be cases where the requirements are somewhat different and usually account for internal processes that are specific to the investment.
Appreciate Senior Lender Expectations
Getting a deal in front of a senior lender early in the process leaves more time to complete the process, often minimizing delays or major issues in closing. The sooner in the process a sponsor brings in a preferred equity investor the better, as the senior lender will be able to run its diligence on the preferred equity investor and provide any legal documents that are necessary. Bringing in a preferred equity investor early on also allows for more thorough diligence on the front end, minimizing delays once a term sheet is signed.
Senior lender expectations can also depend on what type of loan is involved; agency loans such as Feddie Mac and Fannie Mae have specific requirements for due diligence that the lender must perform when preferred equity is involved. Lenders will expect to receive their diligence relating to the preferred equity early enough in the underwriting process so that they can analyze the preferred equity structure and give timely feedback.
If a senior lender is unfamiliar either with preferred equity in general or the specific preferred equity investor, then the sooner a sponsor is able to provide a draft operating agreement, proposed org structure, and any loan modification language the better the process will run. This requires sponsors to have many of the relevant diligence items on their side lined up at the start of the underwriting process, including a term sheet, so any holdups are front loaded rather than popping up right before closing. In addition, more “exotic” deal structures will take longer for senior lenders to review and to negotiate, so again, time is your friend.
In most cases, the preferred equity investor and/or specific loan modification language required when adding preferred equity to the transaction must be approved by the lender.
Best practices include having loan modifications developed specifically to handle requirements of the specific senior mortgage lender, whether agency, CMBS, or balance sheet loans, and getting it to the lender early in the process for review. A preferred equity investor should be familiar with the types of language needed based on which senior mortgage lender is involved in the transaction, and in most cases, the preferred equity investor can add efficiency to the transaction by handling the negotiation of that language with the senior mortgage lender directly.
What It All Means
Adding a preferred equity investor should not be seen as a concern so long as a sponsor does the necessary steps to prepare for the investment. Understanding the timing, requirements, and diligence all help sponsors avoid those holdups or potentially worse outcomes in their closings.
Again, timing is everything. Getting in front of lenders and working out the deal structure early in the process will give sponsors room for unexpected delays, minimize holdups due to lead time on some diligence items, and make it easier to coordinate the requirements of the preferred equity investor.