Is Preferred Equity a solution?

Is Preferred Equity a solution?

Understand how preferred equity can support your property development funding

It is common knowledge the Bank’s loan-to-value ratios have retreated a long way from pre-GFC levels. Compounding this challenge to Property Developers has been the falling ‘As Is Land Values’ and ‘On Completion Values’; not to mention, the higher levels of pre-commitments now required by Banks.

We have all seen the result: thousands of mortgagee in possession site sales, and Property Developers forced to sell development sites at heavy discounts to reduce debt and fund working capital.

Further frustrating Property Developers is the Banks requirement for significantly higher levels of equity in the form of cash to be contributed before they become Bankable. Defining a well-known problem is one thing, developing a viable solution is really what matters.

In some cases, preferred equity may provide part of the solution. So, what is preferred equity? How does preferred equity work? What are the upsides and downsides? How is preferred equity different to mezzanine finance products?

What is preferred equity?

Preferred equity (AKA preferential equity or ‘pref’ equity) is a hybrid of debt and equity financing that DF Partners utilises to fill the gap between what the Bank will fund and what the client is ideally willing or able to contribute towards the Total Developments Costs (TDC) of a project.

Preferential Equity financing is basically debt capital that gives the preferred equity provider the rights to convert to an ownership and control position in the development company under certain circumstances. These may include the loan not being paid back in time and in full, or there being a prolonged un-remedied event of default relative to any loan documentation including senior lender or the preferred equity facility itself.

Preferred Equity versus Mezzanine Finance

How is preferential equity different to the old mezzanine finance? If structured correctly the main advantage of preferred equity versus mezzanine debt is that preferential equity does not require a registered second mortgage or a deed of subordinated debt to be negotiated by senior lenders such as banks.

DF Partners selectively use preferential equity to finance property developments. However, we have also used this innovative form of financing to “sell down” equity and/or pay down and restructure existing debts secured by existing income producing commercial properties.

As the name suggests, the DF Partners’ preferential equity lenders capital and return is secured in priority to the developer and obviously behind the Bank. The pricing of the preferred equity return is generally calculated upon a risk adjusted return on capital basis and must achieve a minimum or floor Internal Rate of Return (IRR).

What are the benefits of preferred equity?

  1. The borrower is able to generate a higher return on equity as their cash contribution is significantly reduced.
  2. Banks are more willing to provide senior debt with preferential equity as they are reluctant to consent to second mortgages for construction projects.
  3. Immediate access to illiquid equity lying dormant in brick and mortar assets.
  4. Ability to restructure debts and rectify potential or existing loan covenant defaults without suffering significant losses due to the forced sale of the asset.
  5. Ability to restructure ownership/equity/partners within existing property portfolios.
  6. The preferential equity participant provides additional experience, capability and strong management support to help manage risk and profitably complete the development.
  7. The reduced cash equity required by the borrower may allow them to take advantage of other opportunities which would not otherwise be possible.
  8. The preferred equity’s returns are usually fixed, reducing the potential for conflict with respect to calculating the “Project Profit”. This gives the Property Developer the opportunity and the incentive to make additional profit if the project achieves profits beyond those originally forecasted.
  9. The borrower is able to bring the project to market faster and significantly reduce holding costs.
  10. By bringing the project to market faster, the Property Developer realises development profits sooner.
  11. Preferred equity provides the bank and Property Developer with an additional source of cash equity in the event of cost overruns beyond the existing contingency budget.
  12. If structured correctly, the addition of the preferred equity participant can make the project more Bankable from a senior lenders perspective.

What are the disadvantages of preferred equity?

  1. As you would expect preferred equity is more expensive than traditional debt and as such it needs to be used wisely.
  2. In the event of a un-remedied event of default the preferential equity lender can enforce step in rights with respect to control of the development company to ensure the project is completed and their capital and return is preserved.

So, there you go, now you are a preferred equity expert.

Naturally, if you or your clients would like to know more about DF Partners preferential equity product, please feel free to contact us to find out more.

DF Partners want to make your next project a success.

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