Preferred Equity vs. Mezzanine Debt

An investor seeking a higher return than that available to a mezzanine lender, and not unduly concerned about exit strategies, can negotiate a senior equity position as a “preferred equity” holder. Preferred equity is most often used when a property is generating insufficient cash flow to service a junior or mezzanine loan, or where the senior lender prohibits subordinate financing. In some cases, a mezzanine lender may choose preferred equity because a debt position could have adverse tax consequences or in some way does not qualify under the lender's investment rules.

Enhanced Rights

While preferred equity clearly is subordinate to all debt, it does have some priority rights over other equity owners. The most important of these is the right to receive a preferred distribution, typically in the range of 12 to18 percent, on the invested amount. The actual rate will depend on a variety of factors. In addition, the preferred equity investor usually has the right to approve all major decisions of the general partner or managing member. Under certain circumstances, the preferred equity holder may become the general partner or managing member.

While the preferred equity holder has priority over other equity holders with respect to distributions, there is no assurance when payments will be made or indeed, if they ever will be made in the event the project fails. Finally, the preferred equity investment often has no maturity date.

Total Return

As noted above, the preferred equity has first claim on equity distributions equal to a designated percentage of its investment. In addition, the preferred equity will share in the capital appreciation of the venture. As a result, the preferred equity holder may receive a higher return than a mezzanine lender whose return is capped. The net effect is to raise the overall cost of capital to the common equity holders as compared to using mezzanine loans, but the benefit is that the carrying costs of the property are reduced.

Using Hurdle Levels

Preferred equity often is used in connection with new developments. Once the parties have agreed as to the amount, timing and form of the equity to be provided, they must agree about the division of returns to the developer and the equity party. The objective is to minimize the downside risk to the equity investor while providing a substantial incentive to the developer partner for the deal to perform in excess of expectations. This usually is accomplished by staging the returns to each party through so-called “hurdle” levels.

Example: Assume the equity partner puts up 90 percent and the developer puts up 10 percent. The initial split might be pari passu, until each party receives 12 to 15 percent of their investment. Additional cash flow would be distributed 80-20 between investor and developer until the investor has achieved a stipulated internal rate of return (say, 15 to 20 percent). Any additional cash flow would be split 60-70 percent to the investor and 40-30 percent to the developer. Since a construction project on an all-cash basis may return only 10 to 11 percent, the returns just described can be achieved only because of the upside leverage provided by the construction loan. A construction loan equal to 75 percent of cost at an interest rate of 8.5 percent increases the overall return to the 15 to 20 percent range.

Cashing Out

An important aspect to be negotiated between the developer and the equity investor is if and when the latter can exit from the investment. Under normal circumstances, the maximum value of the project is achieved only after the project is fully constructed and has been operating long enough to establish a stabilized net income. At that point, the construction lender will be taken out by a permanent loan, but any excess permanent loan proceeds are not likely to be sufficient to pay off the equity investor.

In devising an exit strategy during the initial negotiations, the developer and the equity partner can consider several alternatives. For example, the developer may be willing to sell the project. If the developer is not a merchant builder but wishes to hold the property in a portfolio, the developer may agree to take out a second mortgage or find a new equity partner.