[Editors Note: This is a guest post from Lawrence Fassler, who has guest posted previously and works for RealtyShares, a crowdfunded real estate site for accredited investors. I have an affiliate marketing relationship with RealtyShares, so if you decide to open an account with them, please usethis linkso you and I both get paid a little extra. Mr. Fassler has guest posted here twice before,hereandhere. He titled this post Preferred Equity in Real Estate- Higher Leverage, Higher Risk, Higher Potential Returns.]

Normally, primary lenders on real estatewill not loan in excess of 80%of the propertys value, and generally these first-position loans are more in the 60-70% range.  Real estate owners and developers often try to increase their leverage by financing their projects with capital that is junior to the mortgage debt, but senior to the owner/developer equity.  Mezzanine loans and preferred equity investments are used to achieve this higher leverage.

The growth of mezzanine loans is to some extent directly linked to the growth of commercial mortgage-backed securities (CMBS) which, after a pullback following the Global Financial Crisis, have returned as a primary source of commercial loan financing. In 2009, national credit rating agencies such as Standard & Poors and Moodys required that CMBS offeringsnot include any mortgage loan that also involved subordinate mortgage debt on the property. Because of this requirement, conventional subordinate debt with a second-position lien a junior mortgage was effectively eliminated as a financing option for most commercial projects.

The need for gap financing remained, however, and mezzanine debt where borrowers typically pledge as collateral all of their equity interests in the underlying subsidiaries that control the underlying real property became an attractive form of financing.  Mezzanine loans are also popular with real estate sponsors/borrowers because many of these products offer accrual features that defer portions of the interest payments until the mezzanine loan reaches maturity (a balloon payment). These structures reduce the burden on current cash flow, and thus help the borrowers debt coverage ratios.

The security for these loans the sponsors membership interests in the title-holding entity involves, in the event of default, a Uniform Commercial Code (UCC) foreclosure on the stock (a dependable, though somewhat involved and not super-fast, process). Once the mezzanine lender owns that stock and the associated control rights, it effectively owns the commercial project going forward.

The UCC foreclosure process is tried and true, but is a little unwieldy involving, among other things, a commercially reasonable sale process that involves an auction-type marketing process. While this can be done inside of 60 days or so, its still a bit cumbersome and takes some time and money to orchestrate.  Moreover, some first-position lenders continued to express distaste toward making mortgage loans where mezzanine financing would also be in place; at a minimum, they typically seek inter-creditor agreements that clarify the rights of the two lenders.

Preferred equity arose as a way to have an automatic, self-exercising structure with direct contractual rights contained in the entitys operating agreement.  Preferred equity also avoids the need of an inter-creditor agreement with the senior lender.  Preferred equity also enjoys a better position in any bankruptcy scenario, since equity positions are generally not subject to automatic stay or other constraints imposed by bankruptcy law.

In most other respects, preferred equity is much the same as mezzanine debt; preferred investors get a right to a special (preferred) rate of return, and the right to an accelerated repayment of capital at an agreed-upon date (similar to a maturity date for a loan). Preferred equity also lends itself to more complicated features, such as a cash distribution waterfall that allows the owner/developer to receive some cash flow distributions while the preferred capital is still outstanding, or even where the preferred investors participate in some of the projects upside on top of the otherwise promised return.

While preferred investors do not usually have any foreclosure rights per se, they have specific contract remedies set forth in the entitys operational documents in the event of a financial delinquency or a change of control event. In these events, the managing control of the investment entity would shift to the preferred investors, or the sponsor might be forced to sell the underlying property. Senior lender restrictions against changes of ownership often govern only changes at the lower borrower entity; if they extend to an upper investment vehicle, then sometimes the sponsors retention of its ownership stake will be sufficient (even though it has lost its management rights), while in other cases the preferred member will need to clarify that it will be a qualified transferee under the loan documentation.

Enforcing preferred equity remedies is in some respects less certain than the UCC process utilized for mezzanine loans. Litigation or arbitration as to whether a preferred equity holders remedies have been triggered can result in a delay in enforcement. Properly drafted preferred equity documents, then, typically demand a bad boy guaranty under which preferred investors have full recourse against the sponsor/borrower for any spurious challenge to the exercise of the preferred investors remedies.

Preferred equity investments are in a second position compared to the primary lender, so they are riskier than participations in a first-lien loan.  The return rates are higher, though.RealtyShares, one of the more prominent crowdfunding sites, typically offers investors in preferred equity projects targeted return rates of 12-16%, as opposed to 8-10% on a 1st-lien business-purpose loan.

The default risk with preferred equity depends largely on the remaining equity cushion held by the sponsoring real estate company and the contractual protections surrounding any default.  In the owner-occupied residential world, therecovery rateson defaulting 1stand 2nddebt were at one time estimated by Moodys to be approximately 90% vs. 60%.   Conventional mortgages have a very different profile than the commercial market, though; many private equity firms engaging in mezzanine debt or preferred equity investments use the change-of-control rights involved in such financings as part of their overall business plan. They have active asset managers involved in workout situations, so that their investment is salvaged and perhaps even turned around (since they now effectively control the equity upside in the project). Crowdfunding companies can be expected to follow the same model.

Notwithstanding the post-2008 retrenchment, the past few decades in particular have witnessed

a boom in the creation of structuresfor capital that is junior to the mortgage debt but senior to the owner / developer equity.This need actually increased post-2008as traditional mortgage lenders tightened up their underwriting standards, leaving sponsoring real estate companies scrambling for available capital.  Investors participating in crowdfunding sites likeRealtySharesnow have the opportunity to provide liquidity and additional capital to sponsoring real estate companies needing to fill the financing gap between the senior mortgage debt and the owners equity.

What do you think? Have you been involved as an investor in real-estate related mezzanine debt or preferred equity? Did it work out well for you? Any horror stories? Would you recommend sticking with first position or do you think it is okay to take on the risk of being the second lien holder? Comment below!

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I have been involved in a couple of these deals with a private group, not crowdfunded. As you pointed out, the returns are higher but in the event of default you are going to play second fiddle to the primary lender. In my opinion, track record and due diligence have been key to my comfort in taking on this extra risk you can mitigate but never eliminate it. You want to maximize your chance of success, and not lose your shirt because they dig up an indian burial ground laying some foundation on a new site.

I have not checked out crowdfunding sites, but I would want to make sure track record and due diligence are flushed out before I committed to something like that at arms length. How is that done with something like realtyshares?

If you prefer to do all the DD yourself, then you will probably want to avoid these types of firms. If you want a firm (like Realty Shares) to do some of it for you, then it might make more sense for you to use them. It really comes down to how much you want to invest. If youre investing $5K into a deal, you cant afford to do much due diligence yourself and still have the investment make sense from a return perspective.

Eh as Marketplace lenders/crowdfunding websites are struggling to find investors (I dont feel like googling, just google it yourself), these posts on popular blog are popping up to force investor interest.

Realty shares is just reposting old blog posts. Disappointing.

More like WCI putting blog on auto, leaving for skiing and not doing due diligence to check. He decides to post it, not Realty shares.

Yes, looks like I failed to ensure the article had not been published elsewhere. I usually do that but looking back at my emails, I failed to even ask with this one.

Not sure why youre surprised that the companies are trying to increase investor interest in their investments or what exactly is wrong with that. If you hate the article, well, there will be another one along in a couple of days.

In fact, I am NOT surprised they are clamoring for money. Thats the job of a middle man and they are doing their best, and that is ample evident from a copy pasted previous article on this blog.

Who said I hated it? I am pointing out the obvious journalistic mistake of reprinting prior material.

Its actually a very rare blog that doesnt repost material. Ive allowed my stuff to be reposted elsewhere, but as far as I know, this is only the second time in 5 years that Ive had something posted here that was previously published. Cut me a little slack. And journalistic mistake? Newspapers publish articles from elsewhere all the time. Give me a break.

Give WCI a break! The article will make more people aware of a growing alternate investment market to evaluate.

I have just invested some money in a few of these crowdfunding sites. Its too early to see what happens. I have split the investments between small debt projects with 5K minimums and an equity investment similar to that described above. I wouldnt more than a small fraction of my investment money in these vehicles.

Now, this is the post that I was looking to read for such a long time. I speculate in commercial real estate and I was looking forward to exploring different ways to improve my leverage. Then I stumbled on this insightful blog that gave me the low-down on two of the most important financial products thatll help me in this regard mezzanine loans and preferred equity. Im gonna have to bookmark this page so that I can get to read more of such awesome breakdowns thatll help me make it big in the always-evolving commercial real-estate landscape. Cheers!

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What multiple of gross income is an acceptable mortgage for a physician living in a high cost of living area?

Especially for young high-earners, [retirement] accounts are a money machine. This is one of the few hiccups in the tax code that favors the high-net-worth, so take advantage of the opportunity.