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Capital to the Rescue
A new generation of "preferred equity" aims to help developers and owners challenged by higher interest rates.
Thesis Driven dives deep into emerging themes and real estate operating models by featuring a handful of operators executing on each theme. The deep dives will give an investor enough context to understand the trend as well as opportunities for personal introductions to relevant GPs actively executing on opportunities. This week’s letter is on preferred equity financing—commonly known as “rescue capital”—in multifamily.
The second half of 2022 saw the end of a decade-long period of near-zero interest rates, with the 10 year treasury rising from 1.51% at the end of 2021 to just shy of 4% today, the fastest increase in rates in over 30 years. This was a shock to many real estate owners and developers, especially those who had never operated in an environment of increasing rates.
While the impact of higher interest rates on new development projects is immediate—construction loans are more expensive, and investors demand higher returns—the impact of rates on existing assets takes longer to materialize, as those assets often have existing debt with fixed rates. But eventually loans mature, and owners are faced with the challenging task of refinancing their properties at significantly higher interest rates. In a best-case scenario, owners will simply see their debt service costs rise, eating into the cash flow coming from their buildings. But in many cases, the building isn’t producing enough cash to support increased debt service, forcing the owner to take a smaller loan than they had previously.
This “cash gap” between the size of the old and new loans needs to be bridged somehow, and the past few months have seen the proliferation of numerous firms offering “rescue capital”—usually preferred equity or mezzanine debt—to properties facing this cash gap. Fitch estimates that a quarter of CMBS loans maturing in 2023 will struggle to refinance.
Today we will feature a few GPs tackling this opportunity by offering preferred equity capital to real estate projects and developers. We’ll dig into how each is evaluating deals, structuring transactions, and projecting returns. We’ll also analyze some of the expansion opportunities as well as limitations of the category.
Understanding the underlying problem that owners face today – and the resulting rescue capital opportunity – requires some basic understanding of real estate finance. (If you’re familiar with real estate finance, feel free to skip the next few paragraphs.)
The majority of apartment buildings carry some level of debt. While certain owners—such as high-net worth individuals and family offices—may choose to keep the amount of debt they take on fairly low, others will take as much as their lender is willing to provide to maximize their return on equity capital upon completion of a project. The larger the loan the building is able to take upon completion, the more capital gets returned to investors and the higher promote (a percentage of proceeds above a hurdle) the GP is entitled to receive.
The amount of debt a lender is willing to provide to an occupied, cash-flowing building is usually determined by a Debt Service Coverage Ratio (“DSCR”), which compares the income a building produces to the monthly cost of the debt. A typical DSCR limit might be 1.25x, which means that the debt a building can take on is capped at a level where the building’s NOI exceeds its cost of debt service (interest and principal repayment, if any) by at least 25%. In the lender’s view, a 25% cushion is usually sufficient to protect the lender’s principal against various bad things that can happen at a building, whether on the revenue side (e.g., declines in rent) or expense side (e.g., unforeseen repair or utility costs).
DSCR = NOI / debt service
While owners have historically focused on maximizing the numerator—NOI—of the DSCR formula, their current problems are created by the denominator: debt service. With interest rates (and therefore debt service costs) much higher than they were when most owners received their prior loans that are now coming due, each dollar of NOI can’t support as much debt on the property. So even residential properties with high occupancy and stable NOI are facing a financing crunch. Let’s take the following property as an example:
Revenue: $1M per year
Expenses: $300K per year
NOI: $700K per year
Maximum acceptable debt service: $560K pear year
At a 4% interest rate on a 30 year loan, this property would qualify for approximately a $10 million loan while maintaining a 1.25x DSCR. And during the long period of low interest rates that ended in mid-2022, owners could easily see a 4% rate on long-term, permanent financing. But today, rates are closer to 6.5%. And at the same NOI and DSCR, this property would only qualify for a $7.5 million loan at a 6.5% rate, leaving a $2.5 million cash gap.
Properties have limited options to bridge that cash gap. Buildings generally don’t leave cash on their balance sheets, so the money has to come from somewhere else.
In some cases, a building’s owner chooses to cover the gap with an additional equity infusion. But not every owner has a spare $2.5 million in unencumbered cash lying around, and the thought of putting additional millions into a stabilized building to see no change in cash flow is unappetizing at best.
In addition, larger investors and institutional LPs are likely already overweight real estate in their portfolio, making them hesitant to put more capital into the asset class. Over the past year, other asset types—public equities and fixed income, most notably—have declined in value. With no easy way of marking real estate assets to market, real estate now makes up a larger percentage of many investors’ portfolios than they would like, making further investments in real estate challenging.
Fortunately, the owner may have another option: take a preferred equity investment or mezzanine loan, bridging the cash gap with outside capital while maintaining control of the asset. Today, we’ll spend time with a few of the operators offering these products to understand how they’re approaching the market and the opportunity for owners and investors.
Seth Weissman at Urban Standard Capital is on a mission to fix broken balance sheets, offering preferred equity to multifamily assets with upcoming debt maturities. While mezzanine lending and pref equity financing have always been a part of Weissman’s business, they’ve experienced a recent surge in demand with rising interest rates. “Owners were surprised how suddenly and sharply rates moved,” he notes.
In general, Weissman is providing multifamily owners with relatively short-term (1-3 year) financing that sits in the preference stack between the asset’s senior lender and the owner’s equity. Typically, Urban Standard’s debt costs around 15% per year and represents 10-20% of the building’s value, generally bringing the asset’s leverage up from 55-65% to 75% and bridging the cash gap as explained earlier in this letter. His average check size is $5 million.
Weissman notes that his focus is on “distressed balance sheets, not distressed assets.” As such, he targets multifamily assets with high occupancy and the potential for continued rent growth. In New York City where Weissman is based, for example, a number of apartment buildings still have COVID-era leases in place with rents below current market rate, which he views as additional cushion. “We would need to see a substantial decline in NOI to take a loss,” says Weissman.
However, operating misses aren’t the only risk in Weissman’s business. By taking short-term financing, owners are making a bet that interest rates will be lower by the time these mezzanine loans mature in one to three years, enabling them to refinance with a larger, cheaper loan. But rates can move up or down, and a substantial increase in rates beyond their current level could jeopardize the mezzanine lender’s position in the capital stack. After all, Weissman’s capital sits behind the senior lender in preference, a relationship specified in the intercreditor agreements that must be negotiated on every deal. A further 20 to 30% deterioration in underlying asset value could easily put principal at risk.
Like Weissman, Eric Brody at Anax Real Estate Partners is a veteran multifamily developer now offering preferred equity to stressed assets. But unlike Weissman, Brody isn’t just looking for existing, cash flowing assets. Instead, he’s identifying assets with existing construction risk, bringing his development and operations experience–as well as rescue financing–to get stalled multifamily projects over the line in the notoriously-challenging New York City market. There, Brody is working with several troubled condo projects, shifting them to multifamily (for-rent rather than for-sale) and completing construction work. In general, Brody targets projects that are “3 to 12 months” away from occupancy.
“If you believe in the macro narrative of cities, there’s an opportunity to capture that upside today without taking all the risk,” says Brody. To do this, Brody is writing preferred equity checks between $5 and $25 million per project. He intends to deploy $100 to $150 million over the next 24 months in the strategy with a focus on the New York market and is targeting an 18-22% IRR with a 3-to-5 year hold period. Brody is also bullish on the role of technology in multifamily operations; he launched a venture fund last year and encourages developers who take Anax’s preferred equity to incorporate his multifamily tech stack.
Brody goes out of his way to note that many of the developers taking these preferred equity products are in a challenging situation. “Even in a non-recourse product, many loans have ‘credit enhancement’ structures that allow the bank to go beyond just taking back the keys,” jeopardizing a developer’s personal assets. “Banks love to pretend that they’re your friend, but at the end of the day they want their money back.”
Unfortunately, many existing assets with large, expensive senior loans don’t have enough “room” in the capital stack to accommodate preferred equity. That’s why Eliot Bencuya at Kalcedon Investments is targeting new property acquisitions that are receiving agency (Fannie and Freddie) financing. Agencies tend to be more conservative with their debt, leaving more room in the capital stack for a preferred equity product. “Many deals don’t have enough room between the senior loan basis and what the property is worth,” says Bencuya, making writing larger checks into non-agency multifamily deals challenging.
Instead, Kalcedon follows the agencies where they lend, participating in student housing deals as well as traditional multifamily. Often, agencies are lending an amount equivalent to 55 to 60% of the building’s value (loan-to-value, or LTV), while owners want to be closer to 75%, leaving a 15-20% gap that can be filled by Kalcedon’s preferred equity.
Kalcedon is targeting new property acquisitions, making the initial negotiation simpler than an intervention in a distressed asset. By arranging the preferred equity placement at the acquisition LOI stage, the senior lender—Fannie or Freddie—is able to underwrite them and approve documents up-front, a far less stressful situation than negotiating an intercreditor agreement for a suffering property as a loan maturity looms.
Notably, all of the GPs profiled here are targeting multifamily assets, avoiding office or standalone retail. “Where is the floor [in office]?” asks Weissman. Many multifamily assets are facing financial distress without vacancy or rent issues; office assets are facing operational distress on top of interest rate and financing pressure. Bencuya notes that “there’s no longer any equity to protect” in many office deals, defeating the purpose of preferred equity or a mezzanine loan.
In preferred equity investing, being small can be a good thing. None of the GPs featured here are writing checks larger than $10 to $20 million at most–and in many cases much smaller. Larger deals have institutional owners, and institutional owners are generally unwilling to pay the higher interest rates required by preferred equity providers (and their investors). “Institutional owners are not willing to take 15% equity,” says Bencuya. “They may take 11%, but that’s not what [preferred equity] investors are getting excited about.”
So for now, preferred equity remains the domain of smaller deals and sub-institutional owners, keeping check sizes small. But for those GPs willing to write smaller checks, preferred equity is an attractive mechanism to capture upside while managing risk.
Want introductions to any of these operators? Just reach out to me.