Preferring Preferred Equity
Tom Acitelli Dec. 21, 2009, 4:20 p.m.
Preferred-equity investment structures are emerging as a vehicle of choice strongly suited to many deals in today’s investment market, in some cases even taking the place of senior debt.
This year’s lack of available transactions (due to the lack of motivated sellers) has been well documented. This dearth of closings is reversing as year-end approaches, and it appears that 2010 will see a tangible return of the transaction markets, as a significant number of sellers of various types are becoming more motivated, whether due to internal or external forces.
Stable properties owned by durable borrowers are not changing hands, and that is unlikely to change in the near term. Few if any owners are selling in today’s market by choice-and that will not happen until there is a much longer list of recent sales comps indicating the appropriate cap rates on stable properties for opportunistic (rather than motivated) sellers. Long-term holders continue to view today’s market as a buying rather than selling opportunity.
The properties that are changing hands today have major challenges. But great fortunes have been made buying problematic assets in times of distress, and the appetite for risk has remained in place among developers unscathed (or only modestly scathed) by the downturn. The big change in recent weeks is that developers and other entrepreneurial buyers have begun finding purchase opportunities that are attractive from a risk-reward perspective.
In order for a distressed asset to be attractive to opportunistic buyers in today’s market, certain fundamentals must be present. For residential developments in New York City, the location must be established, active and have either good access to public transit or tremendous charm and established sales history (such as the far West Village). Projects that were either poorly conceived (inefficient layouts) or poorly executed (substandard construction or design elements) will be punished.
Across the hemisphere, some distressed hospitality and retail assets have become available at prices dramatically below replacement cost. For these properties, the upside could be enormous, but buyers and their capital partners will seek to differentiate between good properties experiencing temporary hard times and projects that really shouldn’t have been built in the first place, that are either in poor locations or facing insurmountable physical/design deficiencies. This distinction is easier to spot in some situations than in others.
While there is far more debt capital available in the market than is generally acknowledged, debt sources often do not share developers’ optimism with regard to risk-reward, and for good reason: They only share in one side of it. In more historically normal rental and sales markets, long lists of comps make it seem easier to determine the leverage level at which a senior lenders’ risk profile is low enough to justify its low rates, even on speculative projects. However, with the virtual absence of relevant comps for many projects, this is a much more difficult assessment, making preferred equity’s combination of protection and participation a good fit for many projects.
Preferred-equity investments are not dissimilar in nature to the participating debt structures of the 1980s, although today’s preferred-equity providers are viewing the structure as a way to reduce risk; for thrifts in the ’80s, participating debt was a vehicle used to increase yield by adding risk. The primary sources of preferred money today are equity investors who view preferred equity as a safer alternative to their typical pari passu structures. These are investors who have traditionally viewed the world from an upside-maximization, rather than downside-mitigation, perspective. But in today’s skittish world, being able to tell investors they are entering deals in which outsize returns and their money coming out first are both possible offers a clear advantage.
In many cases today, developers are eschewing debt altogether, and so the preferred-equity providers can be placed in senior positions that allow them to accept “coupon” yields dramatically lower than their threshold returns, and to provide the majority of the capital for the deal. Obviously, these capital stacks only work when the projected returns can support equity yields on large amounts of cash, but those deals are slowly becoming available.
There are several benefits of the preferred-equity structure for the “borrower.” The “coupon” rate is not due on a current basis, and so no interest reserve is required-which reduces the amount of capital required upfront to close the transaction. All of the returns to the preferred-equity investor are paid out of property revenues, at whatever point such revenues actually begin to be received. Repayment guarantees are not required. In a well-structured deal, the preferred-equity investor is truly a partner-sharing both the risks and rewards of the transaction with the developer.
Scott A. Singer is principal of the Singer & Bassuk Organization and a member of REBNY’s Commercial Division Board of Directors. He writes monthly about finance for The Commercial Observer.