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Finally, leases are signed, tenants have moved in and are paying rent,
and a commercial mortgage-backed securities (CMBS) lender has agreed
to provide a fully leveraged, low-rate first mortgage on the property.
Fast forward five years. The mortgage, originally issued with a loan-to-value (LTV) ratio of 75 percent, has been paid down, the property has
had some appreciation in value and now the LTV stands at 60 percent
of the property’s value.
The property owner has an immediate need for cash to resolve a
problem with another property. Maybe he’s even at risk of losing it, but
he doesn’t have the liquid assets to solve the problem. He has significant equity in a successful office property investment, but can’t utilize
it since the terms of his CMBS loan restrict an early refinance without
What is preferred equity?
Traditionally, a property owner can realize the value they’ve amassed by
selling their investment or by monetizing the equity through new debt.
However, in the event the property has a CMBS loan or other restrictive
first mortgage, the investor can’t do either of these things and has to wait
years for the loan to mature until the broker can arrange a new, refinanced
first mortgage. How can the investor obtain new capital immediately
while retaining majority ownership and control of the property?
Preferred equity is an equity investment, but has characteristics similar
to a loan, as opposed to a standard equity investment. An outside company
can provide capital by purchasing a minority interest in the entity that
owns the property. Often, the terms of the “investment” include
an interest rate on the monthly capital infusions, as well as
a specified repayment period. The preferred equity
investor becomes a partial owner of the property, but
deals typically include a prearranged plan for the
borrower to repurchase the investment stake.
The majority owner will pay back whatever
they borrowed, plus a prespecified return
on investment. Over of the course of,
say, one or two years, the borrower
will have repaid the preferred
equity investment and retained full
ownership of the property.
Subordinated debt and mezzanine loans are an alternative to
preferred equity. In a situation where subordinated debt is able to
be used, the lender will have a second or third mortgage position
on the property. There is risk involved in that approach because the
subordinate debt takes a junior position and may not be repaid in full
should senior lien holders foreclose on the property.
When does it work?
There are important considerations that an investor and their broker
should think about before going to the marketplace for a preferred
equity investment. Since this type of investment will typically require a
total return of around 15 percent, it’s necessary to look at what type of
return the borrower will make on the capital he receives.
First, it’s important for a mortgage broker to assist a client in analyzing the property’s current leverage, the terms of the first mortgage and
cash flow to see how much preferred equity the property will support.
In a situation where a property owner is looking to partner with a
co-investor to purchase an undervalued multifamily portfolio, for
example, the investor must determine how he will provide his portion
of the equity to complete the acquisition.
Let’s say the investor has done the analysis and determined the
value-add opportunity will generate an internal rate of return, or IRR,
north of 30 percent. Let’s say the investor only has enough cash on hand
to contribute 20 percent of the equity requirement and a joint-venture
partner is contributing the rest of the equity requirement, but the
investor wants to own more of the deal since it’s an amazing opportunity.
The investor owns another income-producing property, financed with
a CMBS loan at 50 percent LTV.
“The preferred equity investor becomes a partial owner of
the property, but deals typically include a prearranged
plan for the borrower to repurchase the investment stake.”
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