Risk is an inherent and inevitable aspect of any real estate investment. But the devolution of that abstract risk into very real losses, exposure, and liability is not, even in the most highly leveraged and speculative transactions.
Early in my career, one of my mentors told me that all investment and transaction risks arise from three elements:
- Not knowing and/or understanding what you are doing
- Failing to plan for the unseen
- Entering a transaction without thoughtful risk mitigation or exit strategy
That indispensable wisdom has informed all strategies and investment vehicles we develop at Rothschild. It is what forms the foundation of our core philosophical belief that understanding the nature of the risks presented by a given opportunity is a prerequisite to evaluating the likelihood of a lucrative return on investment. It is also indispensable to constructing the guardrails that can minimize the impact of known – and sometimes unforeseeable – risks. We accomplish this through extensive fundamental research combined with thorough, insightful, and actionable analysis of that information.
Preferred Equity v. Mezzanine Financing
The advantages of our approach are crystallized in the preferred equity strategy at the heart of the RCS 35/65 Fund. We designed the fund to lower the cost of financing by developing a term and establishing a CMT rate structure that allows stabilization to occur.
There are two primary vehicles for achieving very high leverage on large commercial projects: mezzanine loans and preferred equity investments.
When part of the financing for substantial development projects, both mezzanine loans, and preferred equity are stacked on top of large construction loans or permanent loans to obtain loan-to-cost ratios as high as 90% of project development cost subject to due diligence.
Preferred equity allows sponsors, developers, and other commercial real estate entrepreneurs to preserve capital, ownership, and control with a cost-effective alternative to utilizing the advancement of project equity from JVEP’s and other capital investment providers.
While both vehicles are designed to accomplish the same thing, how each does so is quite distinct. Unlike mezzanine financing, the lender in a preferred equity investment obtains equity in the LLC that owns the construction project with the promise of a preferred return. If the LLC’s management fails to pay the preferred investor the promised return, the investor has the right and ability to oust existing management and the current members lose their voting rights, as well as any rights to dividends or the distribution of any profits.
Preferred Equity Structuring
Another distinction between the two investments is that unlike mezzanine or subordinate loans, preferred equity investments are typically documented in the organizational documents of the borrowing entity and structured as a third-party investment in the entity by the lender.
In exchange for their capital infusion, preferred equity investors receive interest directly on the property’s cash flow and/or indirectly through a preferred priority return. The investment documentation will usually contain provisions considered to be very harsh to the borrower, including:
- Interest on the invested funds is to be paid monthly, regardless of cash flow or other factors.
- The total investment amount is to be repaid upon the maturity date
- In addition to a default rate with interest and other penalties, the borrowers lose their ownership and management interests.
RCS Equity Real Estate Investment Model
The preferred equity real estate investment structure we deploy at RCS involves investing in the borrowing entity at a level junior to the development debt lender but senior to the borrowers’ equity investments. The preferred equity investment is secured and packaged into a single-asset EJV pursuant to a new formula and streamlined documentation that eliminates all threats of violating the senior lender’s loan agreement.
These threats can arise from the possibility of the preferred equity investor’s potential assumption of controlling ownership and management in the borrower. RCS legal team has developed a workable solution that avoids complications in the event of a default-triggered transfer of ownership to the preferred equity investors.
This new and innovative model developed by Gary Williams is unlike the more traditional approach to preferred equity transactions shown in the image above, offering much higher leverage ratios on the capital stack. This unique blended structure combines elements of private equity, mezzanine debt, and investment finance to provide a stable yet lucrative real estate investment mechanism as an alternative to traditional financing.