Pros and Cons of Preferred Equity Investments
Real estate owners and developers have been increasingly turning toward preferred equity structures and investments in order to raise much needed capital for the purchase, renovation and development of real property where such capital is unavailable from traditional lending sources. Historically, these shortfalls in capital were often funded through subordinate and mezzanine financing. One reason for the increase in preferred equity investments is likely due to the distaste of some mortgage lenders in making mortgage loans where there is or will be subordinate or mezzanine financing in place. However, preferred equity investments are often structured essentially as disguised mezzanine and subordinate financing wherein the third-party investor is promised a certain return on its investment and granted remedies, much like a secured lender, in the event the investment is not repaid in a specified period of time.
Accordingly, these investments raise many of the same issues and pitfalls for lenders as mezzanine and subordinate financings would, including potential transfers of management and controlling interests in their borrower as well as a decrease in the economic resources being available for the property and repayment of their loan. Lenders have responded to these concerns by tightening their loan documents and underwriting standards to limit and identify these structures. However, because preferred equity investments come in many shapes and sizes, there is no "one-size-fits-all" solution available to lenders. Further, borrowers often turn to preferred equity investments late in a transaction when lender underwriting of the borrower and the transaction has already been completed, which inevitably leads to delays in closing and frustration by all parties. This article will briefly discuss some of the problems and challenges to lenders and borrowers raised by these investment structures and some of the ways in which lenders and borrowers have attempted to address these issues.
How are Preferred Equity Investments Structured?
Preferred equity investments in real estate transactions come in various forms and, unlike subordinate or mezzanine loans, are typically documented in the borrower's organizational documents. Generally, the deals are structured as an investment by a third-party investor in the real estate owner or various affiliates in the chain of ownership in exchange for a direct or indirect ownership interest in the real estate owner entitling it to a preferred/priority return on its investment. Sometimes, the preferred equity investment is structured much like a loan where (i) "interest" on the investment is required to be paid monthly by the "borrower" regardless of available property cash flow; (ii) the entire investment is required to be paid by a certain maturity date; (iii) default rate "interest" and penalties are assessed against the "borrower" in the event payments are not made timely; and (iv) a default in the repayment of investment potentially results in the loss of management and/or ownership control by the "borrower" in the company in favor of the investor or other third-party. This type of structure is generally known as a "hard" preferred equity structure and presents the most problems for a lender. Often, this type of structure will require the lender to underwrite the loan much as it would a subordinate or mezzanine loan, and will require the investor to enter into direct negotiations with the lender (much like a mezzanine borrower would negotiate an intercreditor agreement with a senior lender) to ensure that its payment requirements and enforcement rights do not trigger a default under the senior loan. Further, "hard" preferred equity structures often require that the lender underwrite the proposed investor, a process that is both time consuming and labor intensive and could potentially significantly delay the closing of a transaction.
Alternatively, a "soft" preferred equity structure combines elements of the above, but (i) may not require payments of "interest" to be made on the investment unless the property is generating sufficient excess cash flow (after payment of debt service on the senior loan and property operating expenses); (ii) may not have a set maturity date or absolute payment obligation; and (iii) may eliminate some or all of the harsher remedies in the event the investment is not paid back timely. Generally, these investments, which more closely resemble a typical joint venture type agreement between partners, are more acceptable to a lender in that they present less or no interference with the management and cash flow from the property. Adding to the dilemma facing a lender is the fact that because preferred equity investments come in many forms, unlike subordinate or mezzanine financing, it may not be as readily apparent to the lender what type of preferred equity investment is being used for a proposed transaction without a thorough and careful examination of the borrower's organizational documents, something a lender is generally reluctant do in the underwriting stage of the loan. Such analysis is further complicated by the fact that borrowers may not finalize a deal with their investors until the transaction is almost ready to close.
Lenders have responded to the prevalent use of preferred equity structures in two primary ways. First, in the underwriting stages of the loan, lenders have tightened their underwriting standards and are now requiring borrowers to make clear what type of preferred equity structure is contemplated as being utilized. This underwriting requirement puts pressure on borrowers to finalize their deals with their investors earlier than they might have done in the past. Both Freddie Mac and Fannie Mae require multifamily lenders to cause all borrowers to complete, prior to loan approval, detailed analyses of any preferred equity structures to determine whether a "soft" or "hard" preferred equity structure is contemplated. The detailed checklists required by Freddie Mac and Fannie Mae are designed to determine and classify what type of preferred equity is being considered. The analysis of this information often involves the utilization of the lender's legal counsel at an early stage of the loan in order to ensure that the lender understands the type of preferred equity being proposed and in order to address any of the issues that may be raised by the use of such structure.
Second, lenders have responded by beefing up their loan documents to prohibit the use of preferred equity investments, much like the traditional provisions in loan documents that prohibit secondary or subordinate financing. Once again, the devil is in the details and lenders need to make sure that their language is not overly restrictive so as to prohibit ordinary joint venture type investments that should present no issues to a senior lender.
Similarly, borrowers need to read these provisions very carefully to make sure that their proposed structures do not violate these agreements since these provisions are often drafted so broadly so as to prohibit almost any type of third-party investment no matter how far down the ownership chain the investment occurs and no matter how "soft" the contemplated preferred equity investment is intended to be. To make matters worse, violations of these provisions are very often classified as prohibited transfers under the loan documents, which could result in recourse liability to the borrower and any guarantor of the loan. Accordingly, it is crucial for borrowers to understand the provisions and restrictions contained in the loan documents to make sure they are not inadvertently violated.
Key Takeaways for Lenders and Borrowers
Preferred equity investments are here to stay and will play an important role in filling the gap that may be left by traditional financing. It is important for borrowers and lenders to understand that preferred equity structures can often result in issues for lenders and borrowers in real estate financing transactions. Lenders need to understand what type of preferred equity is being contemplated by the borrower early on in their underwriting of a loan in order to evaluate any potential legal or underwriting issues raised by the proposed structure. Borrowers need to disclose and finalize their deals with their investors early on in the underwriting process to ensure that their lenders are able to address any concerns of the investors and issues raised by the proposed structure. Finally, borrowers need to carefully scrutinize the loan documents to determine that the proposed preferred equity structure will not violate the terms of their loan documents.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
“Pros and Cons of Preferred Equity Investments,” by David Brier appeared in the April 27, 2015, edition of Law360. To learn more, please click here or visit www.law360.com. Reprinted with permission from Law360.