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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2017

Tap the Untouchable Value in Investment Properties

Preferred equity financing can be the way to unlock capital for other uses

Tap the Untouchable Value in Investment Properties

When a property owner needs a particular type of financing, they often turn to a trusted commercial mortgage broker to help navigate the marketplace and arrange the most optimal financing for unlocking property value.

If the property in question has an existing mortgage with a high prepayment penalty or costly yield maintenance, however, the broker’s options may seem limited. This is when recapitalization — using a preferred equity investment or, in some cases, subordinated debt — is the answer.

Here’s a common scenario: A vacant office building was purchased with a bridge loan. Many months were then spent renovating and rehabilitating the property, while also conducting the long and arduous process of finding tenants. 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 costly ramifications.

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.

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. 

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 investor would like to somehow monetize this equity for his contribution to the new deal, but it’s trapped within the CMBS loan restrictions and selling the property is out of the question. Recapitalizing with preferred equity is a worthy solution. This way, the investor will obtain the capital needed to increase their stake in the new property, will earn more on the new investment than they’re paying on the preferred equity, and will keep control of the property they already own.

When seeking out a source for a preferred equity investment, it is very important to focus on companies that specialize in these types of deals. 

Another scenario where preferred equity or subordinated debt can be utilized is with tenants-in-common (TIC) properties. Over the years, most lenders have decided the TIC structure is too burdensome for providing first mortgages, since having 20 or more owners that need to unanimously agree to loan terms is a lot more difficult than just working with one owner. It’s possible a TIC property may get into trouble when it’s time to refinance a maturing loan if the broker is not able to find a traditional lender.

In these cases, a lender may require all income from the property be used to pay down the loan, creating another problem for TIC owners. They would still receive K-1 forms and pay taxes on distributions they’re not actually receiving. In this situation, the best solution is a roll-up merger financed by preferred equity or subordinated debt. All TIC owners would contribute their ownership stake to a new entity with one decisionmaker, thereby making it more desirable for a lender to refinance the loan.

In the event some of the TIC owners do not wish to participate in the roll-up and would rather sell, a preferred equity investment or subordinate loan can be used to buy out these owners. The new sponsorship entity would then repay this financing and retain total ownership of the property. Problem solved.

Other considerations

There are a near-infinite number of scenarios where a property owner is able to solve problems utilizing preferred equity or subordinated debt, as long as the investment company providing the capital is flexible, knows how to structure the financing correctly to remain in compliance with the first mortgage and, above all, can move quickly.

General partners can use preferred equity for tenant fit-outs, making interior spaces suitable for occupation; leasing commissions; lender paydowns; capital improvements and partner buyouts. Preferred equity can be used for both long- and short-term deals. When seeking out a source for a preferred equity investment, it is very important to focus on companies that specialize in these types of deals. The details involved in completing this type of financing and staying compliant with the property’s first mortgage can be very complex, and usually there isn’t the luxury of time.

There are situations where a property owner might need to resolve a judgment or lien from some unforeseen circumstance. If they can move quickly, they may be able to settle for a fraction of what the judgment or lien originally was. If the property owner has untapped equity in one or more other properties, a preferred equity investment secured by equity in those other properties may be the perfect way for the property owner to resolve the problem, eliminating both large amounts of debt and a headache that was never anticipated.

•  •  •

Newspapers and real estate journals used to refer to the years around 2003 to 2007 as the “easy-money” days. Although it’s rare that anyone would refer to commercial real estate financing as “easy,” there are always financial solutions to even the most complex situations. Utilizing preferred equity and subordinated debt are two very effective tools for any financial intermediary to recommend to their clients. Small dollars can often fix big-dollar problems.


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