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seeking to ‘ride on
the coattails’ of a
and want to share in
Typically, the sponsor would receive credit for any funds previously
invested in the project and any additional cash that, taken together,
equates to 20 percent of the project’s total equity. Based on a 50/50
split of future profits, the sponsor effectively receives a 30 percent
promoted interest in the project. Alternatively, the sponsor and
equity investor may agree to a multi-tiered waterfall in which the
sponsor earns a higher, stair-stepped percentage of profits when
hitting certain project-level internal rates of return, or IRRs.
As described above, the LLC can issue two classes of preferred
equity — Class A to the preferred equity investor and Class B to
the sponsor. There is no limit, however, to how many classes of
preferred interests the LLC can issue.
As a way to increase the sponsor’s equity from the preferred equity
investor’s perspective, the LLC may issue one or more additional
classes of preferred equity that are subordinate to the Class A interest. The sponsor would receive a Class C interest and the LLC would
issue a Class B interest to one or more of the following parties.
Seller. When acquiring land for development purposes, for
example, the sponsor may form a joint venture with the landowner
and issue Class B preferred equity to that landowner in exchange
for the land contributed to the joint venture.
General contractor. A contractor may agree to invest in the
sponsor’s project via preferred equity as a way to win the contract
or increase their profits.
Lender. The sponsor could issue a Class B interest to a senior
lender that is holding a nonperforming loan so the lender can
pay off a portion or all of the outstanding balance. Alternatively,
the sponsor and equity investor may agree to allow a lender
to purchase a share of common interests in the LLC. In return, the
lender may accept a discounted payoff by reducing the senior-loan
amount and/or interest rate.
Mortgage broker. In lieu of receiving some or all of their fee at
closing, a commercial mortgage broker may accept a Class B interest.
The broker also may negotiate a purchase of common interests
in the LLC. In the previous example, where the parties capitalized
the LLC for a nominal price of $100, the broker would contribute $5
to receive a 5 percent stake.
Class A pricing
Depending on the financial strength of the sponsor and the
preferred equity investor’s perceived risk of the transaction, the
investor may be satisfied with receiving a straight preferred return.
This means they will earn a fixed return on their Class A investment
by receiving periodic payments, similar to a loan, with any unpaid
amounts accruing for additional returns.
Alternatively, many preferred investors are seeking to “ride on
the coattails” of a sponsor’s investment and want to share in
project profits. In order to lock in a minimum return, a preferred
equity investor could negotiate a predetermined “look-back”
IRR — set at a higher rate than the preferred return — or minimum-profit participation.
With respect to establishing a minimum-profit participation, the
sponsor could agree to provide one or more preferred equity holders
with a minimum target price (MTP) that the sponsor would sell the
underlying property for. Investors can calculate their common
interests in the LLC by taking the sales price or the MTP, whichever
is greater, and subtracting the number of preferred equity classes
plus any other property liabilities. This number is then multiplied
by the percent of common interests owned in the LLC to determine
a dollar value.
n n n
Working with preferred equity can be an interesting and profitable
service for commercial mortgage brokers to offer their clients. And
by understanding how to raise preferred equity, brokers also may
be able to negotiate and acquire an interest in the property for a
nominal investment. n
Ron Zimmerman is president of NetLeaseX Capital LLC,
an investment-banking and capital-markets advisory
company in Cincinnati. Zimmerman specializes in
sourcing and structuring debt and equity financing for
commercial real estate investors and developers. He has more than 33
years of experience in the commercial and residential real estate markets
and is a licensed real estate broker. Reach Zimmerman at (513) 621-1031