All good real estate deals are alike. But each deal that doesn’t work out is different. The pandemic hit, occupancy fell, interest rates rose, the lender changed hands, a new building came on the market, lots of things. But they all have one thing in common: they need more money.
The pickings are generally slim. The value of the property has fallen so you can’t refinance. If you sell the property, existing investors along with any chance of raising money from them for future deals will be wiped out. Existing investors don’t want to invest more money and/or they’re not required to (no “capital call” provisions). Often, the sponsor puts in its own money hoping the market changes, but that can’t last long.
The project needs a new equity investment, but in what form? You can’t sell the class of equity you sold originally because new investors want to step to the front of the line and thereby mitigate risk. A type of equity called “preferred equity” is often used in these situations, but it carries risk for the sponsor and existing investors.
What is Preferred Equity?
Preferred equity is equity that acts a lot like debt. The new investor puts money into the deal and receives a fixed rate of return over a specified period of time, like a loan. The fixed rate of return reflects the distressed nature of the asset. Most important, the new investor receives all its money back before other investors or the sponsor receive anything. The preferred equity isn’t secured by the real estate.
Can You Do It?
There are two reasons why a fund might not be allowed to accept preferred equity.
The first is if the lender’s documents prohibit it. Some do, some don’t. Even if the lender’s documents prohibit preferred equity without lender consent, don’t despair. Lenders don’t lose anything by allowing a preferred equity investment. In fact, a chunk of the new investment often is used to pay down debt, turning a non-performing asset into a performing asset and the lender’s balance sheet and lowering its risk.
Depending on your lender and its documents, preferred equity can be easier if the real estate is owned by a wholly owned subsidiary of the fund.
The second is if, God forbid, your LLC/LP Agreement doesn’t allow it. See this blog post on that topic.
Just as your lender should allow a new preferred equity investment, your existing investors should, also; the alternative might be a foreclosure sale. Contrary to classic economic theory, however, investors are sometimes not wholly rational actors. For one thing, they’re angry, especially if haven’t been fully truthful along the way. Even more important, they hate the idea that new investors will step to the head of the line.
In my standard documents, I try to deal with that by giving existing investors preemptive rights to buy the preferred equity, i.e., they can buy it themselves. But having those rights doesn’t necessarily make existing investors cheerful. For example, an investor might not have the cash for a new investment. In any case, it’s not rare that an investor declines the preferred equity yet is unhappy.
Tax Implications of Preferred Equity
Preferred equity is equity. The deals are usually structured as “guaranteed payments” under section 707(c) of the Internal Revenue Code because they are calculated without regard to the income of the fund. That makes them immediately deductible by the fund and ordinary income to the new investor.
Securities Law Implications
Preferred equity is a security. You have to find an exemption.
Speed
If you don’t need the consent of your lender or your investors, preferred equity investments can be completed very quickly, like a week or two. That makes them especially attractive in distressed situations.
Variations – What’s Open for Negotiation
The devil is always in the details. Here are some of the terms open to negotiation.
- Rate of Return: The new investor’s rate of return, of course.
- Payment Schedule: Suppose you settle on a 14% rate of return. That’s not the end of the story. You might, for example, agree that 10% is paid current with 4% deferred.
- Upside: In the vanilla form of preferred equity, the new investors doesn’t share in any upside. Like everything else, that’s subject to negotiation. For example, the new investor might share in the upside after existing investors have received a specified IRR.
- Right to Information: The new investor typically wants a lot more information than you’ve been giving existing investors.
- Consent Rights: Often the new investor will insist on consent rights over major decisions. Many details to negotiate there.
- Forced Sale Rights: After some period, if the preferred equity hasn’t been fully repaid, the investor may force a sale. Up for negotiation are what “some period” means, who controls the sale process, whether there’s a minimum price, the duration of the marketing period, and whether the sponsor has a right of first refusal.
- Removal Rights: Yikes! Yes, some preferred equity investors want the right to remove the sponsor as manager upon defined trigger events. What are the triggers? Can the sponsor cure defaults? If the sponsor is removed, does its promote disappear?
In short, preferred equity can save the day, but with the wrong terms it can also ruin your day.
Questions? Let me know.
Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com