Dislocation in capital markets is spurring demand for preferred equity real estate investments among both borrowers and capital providers.
The precipitous rise in interest rates is constraining loan proceeds and creating a gap in capital stacks between the senior loan and common equity piece. “That is creating an entree into more structured finance, including pref equity, which I think will become more and more critical to bridge that gap,” says Michael Riccio, a senior managing director and co-head of national production for CBRE Capital Markets Debt & Equity Finance.
At the same time, more investors are recognizing the attractive risk-adjusted returns that preferred equity offers in the current market. The growing list of investors targeting preferred equity includes major players such as Mesa West, Invesco, Apollo, Blackstone, Brookfield, MetLife Investment Management and CBRE Investment Management, among others. “These groups are very interested and have raised lots of capital around both pref equity and mezzanine strategies, and I think there is going to be a lot of opportunity to put that money out,” says Riccio.
Some funds have raised money dedicated to preferred equity strategies, and there also are other buckets of capital that aren’t pure-play dedicated funds that have morphed into preferred equity investments, adds Cody Kirkpatrick, a managing director in the JV Equity and Structured Capital Group at Berkadia. “In this environment, it’s a way to manufacture yield when it is difficult to do so with new acquisitions and new debt in the JV space,” he says.
Potentially, investors can realize returns in the low teens, although yields vary depending on the underwriting risk and where preferred equity sits in the capital stack related to leverage. In addition, while investors are giving up some upside in a deal when they invest in preferred equity versus common equity, they’re also limiting their downside as they’re going lower in the capital stack.
“We’re seeing that a lot of traditional JV buckets are risk off relative to common equity allocations both for development and acquisitions because we haven’t seen prices on the acquisition side adjust and there’s a lot of uncertainty out there in terms of interest rates and where cap rates are,” says Kirkpatrick. Renter fundamentals also are becoming more uncertain in some markets. So, investors are looking at preferred equity as a way to put capital out with more downside protection and still get a decent yield, he adds.
Investors cautious on leverage
Overall, the preferred equity market is more competitive today with a significant volume of capital that is targeting the niche. However, that investor interest could be a short-term phenomenon created by the current dislocation of the market. “I don’t think the trend of equity capital coming into preferred equity is going to last in perpetuity. It’s maybe a good stop in the road, but as markets improve and there is more stability, investors will likely shift back to their prior business lines of investing equity capital,” says Matthew Pavlovich, executive vice president and principal at Mount Auburn Multifamily.
Mount Auburn Multifamily has been making preferred equity investments since 2018 with a focus on ground-up multifamily projects throughout the Sun Belt. Since closing its most recent fund in 2021, the firm has been on pace of deploying capital at about one deal per month, and the firm sees plenty of opportunities ahead.
Uncertainty on rising interest rates, valuations and a potential recession ahead also is prompting investors to take a more cautious approach. “Investors don’t want to be over-levered on the back end and put their capital at real risk,” says Kirkpatrick. If cap rates are going to continue to increase, it will impact the "value” in the loan-to-value (LTV) equation. As such, investors are putting in fewer dollars at the front end, because they are looking at a stabilized LTV on the back end with a higher cap rate, he adds. A borrower’s ability to meet debt service coverage also is impacting the amount of preferred equity going into a deal.
Much like the broader capital markets, preferred equity investors are lowering their leverage points. Prior to the start of Fed rate hikes, senior loans were pushing up to 70 percent to 75 percent LTV or loan-to-cost, which meant preferred equity was layering on top at 70 percent to 85 percent range or even 90 percent. These days senior loans are more commonly in the 55 percent to 65 percent LTV range, which means that preferred equity also is lower in the stack, typically in the 55 percent to 80 percent range.
Capital targeting preferred equity is disciplined and investors also are looking carefully at the experience and track record of the sponsor and the particulars of the deal. Market uncertainty also is driving a flight to quality for some investors. “We have definitely tried to swim upstream in quality both in location and sponsor,” says Pavlovich. “We’re really looking to work with top seasoned developers with great balance sheets, track records and so forth, to complete these projects.”
Filling the gap
Borrowers have had to get creative to fill capital stacks in a more constrained financing market. Mount Auburn Multifamily is seeing increased demand from borrowers for pref equity. At the same time, there also are signs of stress in the market and challenges in moving some deals forward. “We’re hearing that some of our developer clients are doing triage in their portfolio and maybe dropping deals that are getting a little thin, keeping the good ones, and then extending land contracts where they can,” says Pavlovich. “So, the opportunity set may be more limited into next year than this year or the year prior.” However, developers with high-quality projects are still getting done, he adds.
Another limiting factor in the supply of deals is that preferred equity is expensive capital, and the numbers don’t always work for the borrower. Berkadia’s Structured Capital Group focuses predominantly on multifamily, and the firm is seeing more demand for development deals versus acquisitions. “Where we also are seeing a lot of opportunity, and where we think there will be more demand, is on recaps,” adds Kirkpatrick. In some cases, sponsors own a property with great debt in place, but they have trapped equity. There is an opportunity to get moderate leverage with reasonably priced pref to come in and repatriate some of that capital so that a sponsor isn’t forced to sell into the current market, he says.
Kirkpatrick advises borrowers to shop the market to find the best options. On some of the processes that Berkadia has run for apartment deals, pricing across the board from very sophisticated investors varies, not only on the proceeds side, but on the pricing side, by several hundred basis points. The market is not as efficient as it was six to nine months ago. “So, for our clients, we’re advocating that you run a process because the days of making two to three calls and getting a couple of options around the same pricing and leverage points are gone,” he says.
Capital chasing a limited supply of deals could squeeze investor yields. “All of that capital wants to be invested in deals. So, I do think there is going to be competition and a lot of pressure on spreads for pref equity and mezzanine financing,” says Riccio. That being said, this is the riskiest part of the capital stack and investors want to be compensated for the risk they’re taking. So, there is a bit of a floor on how much competitive pressure will put on yields, he adds.