Multifamily Borrowers Turn to “Blended” Capital Stacks Given Tight Financings

The Mortgage Bankers Association projected total 2023 commercial real estate lending volume finishing the year 41% lower compared to 2022. If you’re an owner, no doubt you feel the pain—especially if seeking a construction loan. Multifamily borrowers have been confronted with loan-to-cost (LTC) offerings as low as 55-60%. But with challenges come new solutions, and in today’s tight financing environment, one of those prevailing solutions is in the form of adding preferred equity to the capital stack.

Bridging the LTC Gap

What exactly is preferred equity? Preferred equity is sometimes considered a hybrid of debt and equity. The preferred equity is subordinate to senior debt and is typically paid off only after the senior debt is repaid—but prior to cash distributions to the sponsor. In this way, preferred equity serves to bridge the gap between a senior loan and the common equity portion of the capital stack. Given its added risk component versus senior debt, it typically has a “preferred” rate of return, i.e. a priority return of distributions from a borrower’s income and capital proceeds. With that preferred return, the investor usually has limited upside in the profits of a development project compared to straight equity in a project.

So, how is preferred equity coming into play as a solution in today’s multifamily markets? When it comes to multifamily construction, sponsors today are often faced with large shortfalls in their financing needs, given low loan-to-cost ratios. An alternative to a low-leverage loan is to add in preferred equity to cover the shortfall. The result is a blended cost of capital that may differ slightly from a combination of just bank financing and common equity—but it’s an availability of capital that can more readily fulfill development requirements.

A capital stack, for example, might include a 55% LTC bank senior loan carrying a 9% interest rate and 30% in preferred equity at a 17% cost, together providing a blended cost of capital of 10.05%. Granted that aggregate cost would be higher than straight bank debt, but if that bank debt is not to be had in excess of 55% LTC, then a blended rate to achieve development is better than no development at all. The preferred equity is also usually relatively straightforward for the borrower to redeem and exit —typically involving a payoff of the original investment plus any accrued return as well as any required redemption premium (an incentive to the original provider). When considering the cost of common limited partner (LP) equity that preferred equity tends to replace—with LP equity often expecting returns of 20+%—preferred equity is a more cost-efficient alternative. In today’s investment environment, it also eases the burden on a sponsor to raise or bring additional capital into the equation themselves.

Adds Nick Lanni, Senior Director of Credit, Risk and Investments at DLP Capital, “It’s very often a question of moving forward with development construction by filling the financing gap with preferred equity—or not moving forward at all.”?

Plan Ahead

Prospective borrowers need to consider the prospects of preferred equity when negotiating loan commitments and/or senior loan term sheets, since loan covenants can influence capital stack options. Also to be considered is the preferred equity provider’s perspective: preferred equity lenders may have a say in material matters involving a property and/or the ability to manage the property in the event of default. In addition, preferred equity capital is also often reserved for the strongest of borrowers who have excellent track records.

DLP Capital Preferred Equity Program

DLP Capital provides preferred equity investments, on a case-by-case basis, related to single-family rental portfolios, multifamily communities, development of Build-For-Rent housing communities, and RV and manufactured home parks.?

For more information on how DLP Capital can help with preferred equity in your capital stack, contact: [email protected]

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