The COVID-19 pandemic and its fallout have disrupted and destabilized almost all quadrants of the global economy, but few sectors have faced more turmoil than commercial real estate. Lockdown, quarantine, shelter at home—whichever name you use, the impact on many commercial real estate asset classes has been devastating. While the promise of an accelerated vaccine rollout fuels hope for the reopening of the economy and a rebound in underlying real estate values and market functioning, many sponsors and many assets will remain cash constrained for at least the near term. Even if valuations snap back quickly, it will take time for the ramp up of demand and foot traffic to percolate through the system enough to restore equilibrium after a year of forbearance, cutting side deals and shaking loose change from the couch cushions to keep things afloat.
This timing lag creates a rare opportunity for deployment of preferred equity as a form of short-term recapitalization that can, if properly structured, thread the needle between the demands of opportunistic investors, cash-starved sponsors and cautious lenders. The opportunity for soft preferred equity (PE) is now.
In balancing the interests of the sponsor, the mortgage (and possibly, mezzanine) lender and the prospective preferred equity investor, the essential characteristics are (1) how the economic terms are structured, (2) what decision-making role the preferred equity investor will have, and (3) what remedies are available to the preferred equity investor and what criteria can trigger such remedies.
Many alternatives exist for structuring the expected economic risks on the preferred investment. Given today’s circumstances, expect no cash payments to the preferred equity investor until the property has stabilized, any deficiencies on loan payments and impounds have been cured, and there is distributable cash, at which point the preferred investor would sweep everything until brought current on accrued interest. Excess cash flow would begin to amortize the preferred equity investment, with ultimate repayment tied to a capital event in the form of a sale or refinance of the property or a lower cost equity recapitalization.
From the sponsor’s perspective, the upside is that the preferred equity investment puts no strain on cash flow until the property can support distributions. Assuming rent, occupancy and operations return to something close to historical norms, the sponsor can project various scenarios to retire the preferred equity investment workout, giving up control of the asset. Mortgage (and, if applicable, mezzanine) loan documents—and in many cases, pledges of even the beneficial economic interest as well as the actual membership or partnership interest in a borrower—will limit pledges of equity interests. Assuming the intent is to avoid seeking lender consent to the preferred investment (which could also include rating agency approval if the loan is held in a securitization vehicle), the economics of the preferred investment must be tailored to follow the contour of what is permitted under the loan to avoid risking a default (and possibly recourse to the sponsor/guarantor).
Any delegation of decision-making authority that could be deemed a change of control will most certainly violate loan covenants. The sponsor of course will not want to cede control in any way. Given this, how can the preferred investor participate and monitor the status and progress of the property? Assuming customary loan document provisions, the preferred equity investor would be able to demand operating statements and other financial information even beyond what the loan documents might require. Also negotiable would be consultation rights, likely veto rights over major decisions and the parameters for mandating the marketing of the property and the terms of any sale or refinance of the property if the cash flow for the operator fails to adequately amortize the preferred investment.
For the preferred investor, the endgame is the starting point: How do I get taken out whole with all accrued interest, and what happens if I don’t? Unfortunately, with “soft” preferred equity, the best the preferred investor is likely to get is the ability to seek any distributable cash out and possibly to compel the sponsor to seek to sell or refinance the property.
A shorthand way to refer to preferred equity investments is “hard” versus “soft,” with the key distinction being that “hard” preferred equity is akin to an equity version of a mezzanine loan that carries with it the right to take over management of the property if certain payment terms are not satisfied. While obviously more attractive to an investor, such a position would require the consent of the mortgage lender (and negotiation of a recognition agreement along the same lines as the intercreditor agreement between a mortgage lender and mezzanine lender). And of course a deal sponsor will be loath to give up control of its project. Soft typically means a preferred return but with no remedies attached.
In the current context, the overall economic structure would look something like the “top off the tank” loans that were popular in the early 2000's as sponsors look to take advantage of rising property values without incurring the cost of refinance with defeasance. The need today is more short term—a means of keeping a deal from going upside down until the economy stabilizes and with it (hopefully) cash flow and valuation. There are no easy answers when cash runs short on a leveraged property, but for property owners willing to craft a deal, soft preferred equity can be a winning ticket.
Carson Leonard is partner at Alston & Bird. Carson has more than 25 years of experience working with banks and institutional investors on all manners of commercial real estate debt.