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The structure of preferred equity in commercial real estate and multifamily lending and investing (sometimes called junior equity) can get very complex but the idea behind it is simple.
Preferred equity is often reserved for larger commercial real estate deals over $10 million and sits on top of debt in the capital stack. Most often it will sit on top of a first and second lien and is therefore junior to them (which is perhaps where the term junior equity comes from). Preferred equity and mezzanine financing can help borrowers leverage a transaction as high as 95% LTC
Preferred equity is there to reduce the capital requirements of the borrower, but is available at a great cost (usually a substantial amount of equity in the property) and is mostly available on substantial value-add transactions, construction/development, or in the case of special tenants or special properties (perhaps historical or in important locations). Quite often mezzanine loans may be structured to include a preferred equity component. Preferred equity is also used in commercial real estate and multifamily finance in the case of senior lenders (first lien holders), that don’t allow for subordinate debt debt.
The borrowing entity, after obtaining a preferred equity investment, usually maintains all control over the property, but in the event of a default the preferred equity investor would take over in managing the commercial real estate. This is usually done by doing a UCC foreclosure on the membership interest of the LLC that owns the piece of commercial real estate so as to take control of the company, and therefore the project.
Let’s say you’re an experienced commercial real estate developer and you’ve found an old warehouse in Manhattan that can be purchased on the cheap, refurbished and converted to retail on the bottom with lofts at the top. You’ve already arranged NNN leases with national credit tenants. The upside potential may be huge. You’ve handled all zoning issues, negotiated the deal, and have the money to do the deal, but you need to keep liquidity due to covenants in other outstanding loans and projects. In this case you may need higher leverage financing and junior equity to get you to where you need to be.
The funny thing about high leverage commercial real estate loans is that they are there mostly for the borrowers that under any other circumstance wouldn’t normally need it.
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