Analyze This - Preferred Equity in Real Estate Transactions

Analyze This - Preferred Equity in Real Estate Transactions: Your Guide to Unlocking Trapped Value, The Mann Report,  Denise Mann
October 2002

As a result of the recent real estate boom, a property owner is looking to refinance and recapture some equity from her multifamily residential property. Her initial 70% Loan-to-Value mortgage is now a 50% Loan-to-Value mortgage. Unfortunately, her securitized first mortgage prohibits secondary financing as well as a pledge of ownership interests. While the value of the property will support a larger loan, her equity is "trapped" until the first mortgage matures or is defeased. See the problem?

Enter Preferred Equity, an option that gives the owner access to some of the trapped value, which she can re-deploy on the next project. How? That additional 20% of value can be offered to preferred equity investors to whom the property owner will pay a fixed dividend, rather than interest.

The above example highlights the core difference between mezzanine debt and preferred equity deals. While many in the real estate world have come to see these as two different names for the same structure, this is not the case. With preferred equity deals, the preferred equity holders receive a true equity stake (i.e., an ownership interest) and are usually paid both a preferred return and a piece of the “backend”. While it may not be immediately apparent, this structure affords benefits to both the property owner and the preferred equity holder.

First, the preferred equity investor acquires direct involvement with the property owner and the management of the property. This enables the investor to better protect their initial investment and potentially share in the project’s growth over time, thereby increasing the return on investment.

Second, from the property owner's perspective, the equity nature of the investment will not violate any secondary financing prohibition erected by the first mortgage holder. While a preferred equity structure may potentially run afoul of the ownership transfer restrictions often contained in first mortgage documents, as Jonathon Yormak, a New York real estate attorney at Fried, Frank, Harris, Shriver & Jacobson points out, "many mortgages permit borrowers to make limited transfers of ownership interests in the property owner without the existing lender's consent, usually so long as certain individuals or entities retain either a minimum level of ownership and/or managerial control over the asset. In such instances, unless the ownership requirements are violated or the preferred equity holder is assuming managerial control, the preferred equity structure may be implemented without obtaining the first mortgage holders’ consent." Furthermore, Yormak says, "in those limited instances where a first mortgage does not contain any restrictions on the transfer of ownership interests, the first mortgage holders’ consent will not be required at all." Clearly, avoiding both the secondary financing prohibition and, potentially, the need to obtain the consent of a first mortgage holder makes the preferred equity structure an extremely attractive option to a property owner seeking to unlock "trapped" equity.

The positive attributes of a preferred equity transaction benefit both the investor and the property owner, so it is no wonder that such deals are a growing trend and the roster of private direct investors utilizing the preferred equity structure is increasing. In addition, more and more of the non-institutional private direct investors who have been in the mezzanine/bridge loan business are discovering preferred equity as a way to create additional upside for their funds without upsetting the delicate relationship with their limited partners.

“Preferred Equity deals have given us the opportunity to work closer with our clients since our goals have become completely aligned, and this is already showing signs of better than expected returns,” says Michael Boxer partner of RCG Longview, LP, a New York City based direct investment fund.