Higher interest rates and a pull-back in available joint venture equity have led to increased use of preferred equity in the capital stack for multifamily, seniors housing and student housing developments for the past few years. Now, after more than two years of sustained higher interest rates, the landscape is beginning to change. With interest rate volatility and potential decreases ahead, multifamily investment dynamics may be shifting, says Matthew Zisler, head of Greystone Equity Services.
Cost of Capital Spurs Pref Demand
“Before interest rates went up, apartment investors could borrow as much as 75% to 80% of a property’s purchase cost or market value on a refinance, but as rates changed from 3% to 6.5% or higher, investors found they could only borrow up to 60% to 65%,” Zisler says. “Many commercial property owners found themselves in the unexpected position of needing additional funding sources to complete their capital stack.”
That’s where Greystone came in with a preferred equity solution, particularly for Agency loans (Fannie Mae or Freddie Mac) for stabilized properties, which must follow stricter guidelines.
“The Agencies require us to do a deeper dive into the property and the sponsor, which gives investors more confidence,” Zisler says. “We’re still seeing low acquisition volume, which means there’s less new data to support values. When it’s harder to figure out where value is, investors pull back in their risk tolerance. Many equity investors decide they would rather take a lower return but at lower leverage on a stabilized asset than invest in new common equity on a transitional asset. Many institutional investment managers look at preferred equity as a better risk-adjusted return while they wait for changes in the market to get back into joint venture equity.”
Typical pricing for preferred equity today is 12% to 14%, with some deals reaching higher than 14%.
As interest rates begin to decline, Zisler anticipates that preferred equity deals may begin to fade in favor of traditional joint venture equity deals. Lower rates increase loan proceeds, which means the need for preferred equity is starting to shrink, he says.
Preferred Equity Sources
“While institutional investors occasionally use preferred equity, local and regional owners and operators are more likely to rely on preferred equity to complete their capital stack,” Zisler says.
“Local or regional owners see preferred equity as providing either a cheaper cost than if they had to raise the equity themselves, or as a source of capital that will help them live to see another day,” he says. “In other words, if they didn't do this, they might have to either sell the property at a lower price than they would ever prefer, or in the worst-case scenario, they might have to turn the property over to the bank. Preferred equity helps avoid these scenarios today.”
“The sources of preferred equity have changed over the past decade or so,” Zisler says.
“Similar to how the mix of buyers has evolved and expanded, we see interest in real estate preferred equity from credit funds, insurance companies, new investment funds and family offices, in addition to the traditional larger investment managers,” he added.
Preferred Equity Opportunities
Typically, preferred equity is used for refinancing stabilized properties rather than for transitional, value-add properties. There are more refinancings with preferred equity than acquisition financings due to shorter closing time constraints and fewer acquisitions.
As interest rates eventually come down, even if they don’t fall as low as they were in the past, borrowers have the opportunity to get more proceeds from their senior loans. That could eventually lead borrowers to relying on higher leverage senior loans and their own equity or, depending on their cost of capital and views on leverage, to continue to seek out preferred equity, Zisler says. For many borrowers, preferred equity is still a cheaper source of capital than their own sources of equity.
Preferred equity investments are often smaller than similar JV equity investments and the cost to close and administer those investments stays relatively the same even as they get smaller. “Preferred equity investors are going to carefully evaluate where they are coming into the capital stack,” notes Zisler.
Borrowers may have to decide between a higher leverage senior loan and raising their own equity and restricting their senior loan to more moderate leverage (hopefully in exchange for a lower rate) to allow preferred equity. Until there’s more price discovery and investors feel more confident about values, which could take a year or more, JV equity is still more challenging to place than preferred equity.
“Our group has created an efficient process for borrowers and preferred equity investors,” Zisler says. “We provide the information that investors and owner / operators need so they close with a senior Agency loan from Greystone at the same time.”
Typical Terms
Preferred equity investments are typically five- to ten-year investments, with most borrowers opting for five-to-seven-year investments. Agency loans are also typically five- to ten-year loans. Preferred equity investments must be coterminous with the Agency loan and cannot have a maturity date prior to the senior loan.
“We look at Agency loans as a good place for new preferred equity investors to start because of the stability of the property as well as the level of due diligence that both Agencies go into on the property and the borrower level,” Zisler says. “But we’re seeing more people ask about preferred equity behind various types of loans, including bridge loans, construction and CMBS.”
The sweet spot for Greystone’s preferred equity opportunities right now is in the “$2 million to $10 million range,” Zisler says, although there is plenty of preferred equity above $10 million.
“We’ve closed on $2 million of preferred equity behind a $20 million loan and on $6 million of preferred equity behind a $56 million loan where there is wider variance in pricing,” Zisler says. “When you get into deals over $10 million, there is more interest from the larger institutional funds who are willing to compete on price and proceeds for the right opportunity.”
In addition, there are debt service coverage limitations and limited value constraints. While there are some exceptions, 80% is typically the maximum loan-to-value for most preferred equity investors.
“Until lower rates and more confidence on values kick in to encourage more JV equity deals, preferred equity may be a compelling alternative for better risk adjusted returns,” Zisler says.