How to Fill the Gap: Structuring Capital Stacks in the Current Economic Environment
By Eli Moghavem
It has been increasingly more difficult to structure real estate transactions in an inflationary environment. As values stay stagnant, the cost of capital has increased. Investors have had to settle for less yield, more risk and unfavorable terms with lenders and equity providers just to get the transaction closed.
Some of the main drivers creating underwriting challenges are: 1) higher interest rates have squeezed available operating cash flow and 2) increased closing costs to price in the cost of derivatives (caps and swaps) and 3) lender-held interest reserves. Despite these difficulties, investors must remain disciplined in underwriting, staying focused on debt yields, first mortgage financing terms, adequate working capital, cap rate inflation, market rent decline or stagnation, higher cost of take-out financing and LTC attachment points.
Investors are now looking to financing alternatives to get their transactions to still “pencil”. Preferred equity has become the saving grace for many real estate transactions. Preferred equity can help bridge the gap created by both the debt and equity markets, and can often times be accretive to investor returns.
The Debt Gap: The debt markets have experienced a quick and substantial contraction, which is causing a large tapering back of leverage on real estate transactions. Whereas debt funds were lending up to 80% loan to cost in March/April, they are now constrained to 65-70% leverage. This is creating a larger gap in the capital stack, as people who would have traditionally financed their property with a cheaper first mortgage, now have to come up with more equity for closing. How preferred equity can help:
1) Preferred equity can be analyzed by an investor as another form of debt. An investors can look at their first mortgage plus preferred equity for a blended cost of capital which may not be much higher than what they are typically used to.
2) Preferred equity can be relied on for its certainty of closing, so investors can focus on deal closing and operations rather than having enough funds to get the transaction closed.
3) Because investors are now putting in less equity into their transactions, they will have more equity for reserves or to close other transactions.
The Equity Gap: As the debt market contract and the stock market has experienced major volatility, LPs are sitting on the side-lines, waiting for some certainty in the market. Sponsors who traditionally capitalize their transactions with common equity structures, now look to preferred equity to fill this equity gap:
1) Sponsors can backend a large portion of their preferred equity payments to not create such a drag on ongoing cash flow
2) Preferred equity can be structured so their common investors can still receive some cash flow during the property transition period.
3) Sponsors can find programmatic relationships with preferred equity providers. As sponsors depart from their common equity structures, which are less accretive to the GP, these sponsors are looking for a reliable equity partner they can come to on every deal.
4) Preferred equity is finally being recognized as a more developed asset-class, but still lacks an institutional allocation, which allows an opportunity for more creative capital stack structuring.
Preferred equity: a win-win-win
Preferred equity has become the problem-solver in today’s market, given the inflationary environment and volatility.
The capital markets/brokerage community benefit from preferred equity because they typically get paid more for equity placements than they would finding the debt. Majority of preferred equity transactions are sourced through the capital markets brokerage community. Equity placement generally expects a 3% equity placement fee, versus a 1% fee for debt placement, indicating the lack of supply in the equity allocator space.
The lenders benefit from preferred equity because it can be a vehicle for them to get their loans closed when they are constrained on leverage. When lenders now are maxing out leverage to 65-70%, preferred equity can bridge the difference up to the original sponsor expectation. This allows the lenders to still remain competitive and originate loans.
The sponsors benefit from preferred equity because their LPs are sitting on the sidelines, their lenders are coming in short of leverage, and it is generally accretive to GP returns, given flexible pre-pay and structures that allow the preferred equity holder to get a return through a combination of current pay, backend profits, and accruals. Preferred equity will generally be more flexible and cheaper than traditional common equity structured and syndications and with the right partner will be guaranteed to show up to the closing table meaning certainty of close in an uncertain environment where LPs can be unreliable.
Current market dynamics are creating large gaps in the capital stack, that are not able to be filled with traditional financing structures (debt is limited, and LP equity is scarce and undependable). Preferred equity should be considered on these transactions as an accretive equity alternative for sponsors who may be struggling to get transactions closed in an inflationary market.
Eli Moghavem is a founder and principal at Base Equities.