If you’re in the market for gap financing (capital that sits between senior debt and general partner equity in the capital stack), preferred equity might be a great solution for you. In this blog, we will explain what preferred (aka “pref”) equity investors look for in a deal. It’s always a good idea to understand what your potential capital providers are looking for and motivated by. 

Before we begin, keep in mind that every deal is different and each pref equity provider will look at deals differently as well. There are general rules of thumb but specific structures will continue to change and there is no “one size fits all.” As with most things in CRE, everything is negotiable and subject to change. 

Remind me. What is Pref Equity? 

Preferred equity is a type of equity that is given preferential treatment over common equity. In the event of a default or bankruptcy, preferred equity holders will be paid back after senior debt, but before common equity holders. Preferred equity is often used in commercial real estate financing to provide additional capital to a project without incurring debt. The preferred equity provider is technically a member of the owning LLC. Thus, their rights are guided by the LLC Agreement. The LLC agreement will dictate what happens if there is a default. Unlike mezzanine debt where there is a technical foreclosure, the preferred equity member’s rights are automatically updated based on the terms in the LLC agreement. 

What Do Sponsors Do Wrong? 

Since the word “equity” exists in “preferred equity”, Sponsors mistakenly think that they should pitch these capital providers in the same way that they would pitch Limited Partners or Co-General Partners. This confusion is understandable. However, pref equity providers do not usually participate in the profits. Thus, presenting metrics such as internal rate of return (IRR) or equity multiple (EM) are nice, but they do not mean much. 

What Do Pref Equity Providers Focus On? 

Pref equity providers prefer to focus on downside risk rather than upside potential. They typically have a fixed rate of return, targeting between 12-17% per year over the hold period of the deal. In conversation, you may hear professionals characterize this as “hard” pref equity if the structure is more debt-like. Sometimes, the pref equity provider might negotiate for profit participation on top of charging their interest rate. Hard pref is more debt-like in that there is a consequence if interest rate payments are missed. 

On the other side of hard pref equity, you may hear professionals also discuss “soft” pref equity if the structure is more equity-like. Soft pref is more flexible on distribution of their interest rate. In the event of default on a payment, there are no ramifications and the interest payment can simply accrue to the balance. Thus, the final payoff will be larger than the beginning balance (original balance + accrued interest). 

Many preferred equity investments fall somewhere in between “hard” and “soft”. In these instances, they are more negotiable to a lower interest rate in exchange for the upside economics.

Other important considerations: 

• While certainly there are pref equity providers that will invest less than $5 million in a transaction, many more try to stay above that threshold as a minimum check size. Their reasoning is that it takes as much work to do a $10 million deal as a $1 million deal and they are getting paid an interest rate based on their investment size. 
• It is also important to consider the interest rate of the senior lender ahead of them and whether it is fixed or variable for a long term. Floating rates or bridge debt can be seen as too risky in a volatile interest rate environment unless the Sponsor purchased a “rate cap” (aka insurance policy against rising rates). Since pref equity providers get paid back after the senior lender, pref equity wants to ensure that the debt service payments on the senior are comfortable even under potentially stressed situations. 

Main Underwriting Metric

A very important underwriting metric for pref equity providers is “Yield On Cost” of their last dollar exposure, and making sure there is a comfortable spread against cap rate/interest rates. 

That was a mouthful so let’s break down each part. 

• Yield On Cost = the rate of return of an investment based on taking the net operating income and dividing it by the total cost of the investment. 
• Last Dollar Exposure = the total amount of deal financing when considering both senior debt and preferred equity. 
• Comfortable Spread = “comfortable” will differ from one firm to another but let’s assume a rule of thumb of 200-300 basis points above the cap rate. 
• Cap Rate = the rate of return of a cash-flowing property based on taking the net operating income and dividing by the purchase price or property value.  

Now let’s rewrite that first sentence: 

A very important underwriting metric for pref equity providers is the rate of return based on taking the net operating income and dividing it by the combined total of the senior debt loan size and the pref equity investment size. Pref equity providers want to ensure that this financing-specific rate of return is 200-300 basis points above the property-specific rate of return. 

Now let’s rewrite that sentence to say it another way: 

Whatever rate of return the property is expected to generate if the Sponsor paid all cash, the pref equity provider wants to ensure they will make 2-3% more than that if they had to take back the property and the Sponsor’s common equity was wiped out. 

Example 

Let’s assume these deal parameters:

• $100 million = Total Deal Size
• $60 million = Senior Debt
• $15 million = Preferred Equity 
• $5 million = Net Operating Income
• 5% = cap rate 
• 2% - 3% =  yield on cost spread over cap rate expected by pref equity 

In this example, the preferred equity provider’s total exposure is $75 million ($60 million + $15 million). Dividing $5 million by $75 million, their yield on cost  on this deal would only be at 6.67%. Since the cap rate is 5%, this pref equity provider will want between a 7% - 8% yield on cost. Thus, the 6.67% is too low. The pref equity provider will then offer a lower check size in order to cure this. 

The maximum last dollar exposure that this preferred equity will accept is calculated by dividing $5 million NOI by 7% yield on cost minimum. Thus, $71.4 million is the maximum last dollar exposure. Since the senior debt is set at $60 million, the maximum pref equity investment that this provider will offer is $11.4 million (rather than the $15 million originally requested). 

Conclusion

In conclusion, the above are only general guidelines and specific pref equity financing structures will be negotiated deal by deal. Sponsors should understand that pref equity acts like a form of leverage. It may increase returns, but it also increases risk.

…

Good luck out there my friends. 

I’m happy to engage with you in the comments so that everyone can learn. If you prefer to share privately, feel free to email me at huber@stacksource.com

‍