Preferred equity plays are on the rise, but what’s the catch?

For developer Ian Bruce Eichner, who famously lost his Cosmopolitan hotel project in Las Vegas during the financial crisis, investing in real estate has been something of a tightrope act.

When Eichner bet on Manhattan’s luxury condo market with his 83-unit Flatiron project at the peak of the cycle, he turned to preferred equity players Dune Real Estate Partners and Fortress Investment Group — both known for seeking out high returns. And after a drawn-out legal battle with both firms, he narrowly escaped losing the development last year after landing a $167.5 million first mortgage from Madison Realty Capital using the unsold portion of the 60-story tower as collateral.

The move raised more than a few eyebrows. It’s no secret, after all, that Madison has foreclosed on a handful of borrowers who got in over their heads, including the infamous East Village landlord Raphael Toledano.

In the rising world of preferred equity, that 11th hour rescue could be a harbinger of things to come for more than just Eichner.

Such investments, which take a front seat to an investor’s down payment when it comes to the payback pecking order, have become a critical source of financing for New York real estate projects in recent years. As the market recovery extends to extra innings, a growing number of sponsors are opting for preferred equity over subordinate debt to give themselves more of a cushion, according to those who negotiate financing for a living.

Anthony Orso, head of Newmark Knight Frank’s capital markets team, called it “an easier way for owners to take some chips off the table and not be in a position where they overleverage their properties.”

Steve Kohn, who leads Cushman & Wakefield’s structured finance team, echoed that point, noting that it “may be a less expensive way to raise capital than refinancing the senior mortgage at a higher level”— especially when the senior lender wants to impose a prepayment penalty.

But others say preferred equity could lead to messy situations for some developers in the case of a downturn.

Unlike common equity from a developer and outside investors, preferred equity typically comes with fixed scheduled payments and returns that can run as high as 15 percent. Those terms come with their own pitfalls, which could wind up at the heart of some crumbling deals in New York City, said real estate attorney Edward Mermelstein.

Cracks are already showing with the oversupply of luxury condos and the same could occur in the office and retail markets, as spaces go unrented, he added.

The rise of preferred equity also coincides with a slowdown in EB-5 funding, which many developers had turned to after the crisis. A lot of the capital provided through the federal visa program will need to be replaced in the coming years, adding additional costs and complications to some real estate projects.

“Today, it’s hard to raise any type of equity,’’ said Mermelstein, who compared New York’s real estate market to 2009 and argued that “very few projects make sense.”

“Many of these projects need to be refinanced, and there’s no ability to do so,” he added.

Many of these projects need to be refinanced, and there’s no ability to do so. Edward Mermelstein, Rheem, Bell & Mermelstein

Outside the box

In filling the so-called capital stack for construction projects and acquisitions, preferred equity typically falls in the gray area between common equity and senior debt. In cases where there’s a large gap between the two, it can become the deciding factor in a deal.

One of the biggest benefits, sources say, is that if revenue falls short of pro-forma estimates, a project’s primary sponsor can retain a stake as a limited partner with limited upside, in a worst-case scenario. A mezzanine lender, on the other hand, can foreclose and seize an asset — leaving the majority owner with nothing.

“It’s probably easier to do a preferred equity structure than your typical joint venture,” said Michael Campbell, the new CEO of the Carlton Group, which brokers debt and equity deals for borrowers.

Though preferred equity has many of the same characteristics as junior debt, payments can be delayed until it’s most fortuitous for the equity holder in control of the asset. With a large condo project, for example, returns can be postponed until units start selling, according to those in the business. And in some cases, the capital can sit in reserve only to be tapped if a project runs into problems.

Those flexible terms can allow for negotiations that are virtually unheard of with traditional bank loans and even nonbank debt deals.

At Gary Barnett’s 95-story Central Park Tower, $235 million of preferred equity came from an unnamed hedge fund that has the option to convert its investment into condo apartments once the project’s completed. That deal carries a fixed interest rate of 11 percent until December 2021, according to documents filed with the Tel Aviv Stock Exchange in January 2018.

The 179-unit tower, which has a projected sellout of $4 billion, will become the tallest residential building in the city when it’s completed, and the first to try to sell 20 units at $60 million and up.

Barnett’s Extell Development and joint-venture partner Shanghai Municipal Investment cobbled together a $1 billion-plus financing package for the tower in the final hours of 2017. In addition to the preferred equity and a $900 million loan from a group of banks led by JPMorgan Chase, funds for the project are coming from foreign conglomerates, Israeli bondholders and the luxury department store chain Nordstrom, which is opening a new location in the tower’s base, the TASE fillings show.

A spokesperson for Extell declined to comment.

Strings attached

Daniel Berman, a real estate attorney with Kramer Levin, said there’s less confidence in 2019 that big projects are going to gush money, making all investors happy, while some senior lenders may impose restrictions blocking subordinate debt — which preferred equity can be a way around.

He referred to it as “savior capital that makes a deal happen.”

But even with the protections that preferred equity offers, “it’s a little bit funky,” and the strings attached can create issues for developers, Berman added. The problem in many cases is that by bringing in preferred equity, a developer takes on investors that may compete for control of the project should trouble arise.

Mermelstein said he’s seeing newly created funds that are looking to acquire distressed projects at cents on the dollar. Having preferred equity instead of mezzanine debt won’t protect the primary sponsor when push comes to shove, he added, noting that a lot of “new developments are hitting brick walls.”

In the city’s luxury condo market, for example, the volume of new development sales tumbled nearly 40 percent in the first quarter of the year, compared to the same period in 2018, according to a Douglas Elliman report from April.

In the case of Eichner’s project at 45 East 22nd Street, the developer had sued his preferred equity partners, alleging they pushed him to the brink of default by interfering with his efforts to refinance the project.

Eichner declined to talk about the project’s financing and representatives for Dune and Fortress would not comment either.

But Josh Zegen, one of Madison’s three managing principals, said his firm’s loan smoothed over tension between the preferred equity providers and Eichner’s Continuum Company. Since then, he added, the condo project “has sold very well,’’ with about a third of the 24 units that were on the market at the time either closed or under contract. His company’s loan has now been “substantially paid down,” Zegen noted.

Madison has also taken preferred equity stakes in other projects, according to Zegen, including a $90 million investment in Michael Stern and Kevin Maloney’s Steinway Tower at 111 West 57th Street.

Condo units that are complete or nearing completion have a pricing advantage over product that is still in heavy construction, according to Zegen. “There’s been a capitulation on the sellers’ side,” he said. “If we want to move inventory, there’s got to be pricing adjustments.’’

Preferential treatment

Craig Solomon, CEO of the real estate investment firm Square Mile Capital, said he’s found steady demand for preferred equity in recent years and that his company looks for returns in the mid-teens on most of those deals.

Since 2013, Square Mile has injected nearly $1.5 billion of preferred equity into 22 assets in New York, Chicago and other markets with a combined project value of about $5 billion, according to the company. Those deals include Simon Baron Development’s 43-story Alta tower in Long Island City, which Square Mile invested $138.5 million in last fall.

As the recovery reaches the 10-year mark, Solomon noted, those kinds of deals have become “a central theme” of Square Mile’s investment funds.

“We strive to provide solutions up and down the capital stack,” he told TRD by email. “Preferred equity has become a growing and very successful component of that strategy.”

Others that have made preferred equity investments in notable New York projects include Eyal Ofer’s Global Holdings Group, which recently put $52 million into Rockefeller Group’s NoMad condo project at 30 East 29th Street. Global Holdings also invested $100 million of preferred equity in 25 Kent, Toby Moskovits and Rubenstein Partners’ 500,000-square-foot office project in Williamsburg, Brooklyn. The recently completed building has yet to announce its first tenant.

A spokesperson for Global Holdings said preferred equity allows the firm to structure its capital to match a project and sponsor’s needs  “in ways that most funds cannot,” while a spokesperson for Rubenstein called it a “standard investment structure” and “another affirmation of confidence in 25 Kent and the Brooklyn market.”

Representatives for Moskovits’s Heritage Equity Partners did not return requests for comment.

I have a feeling that it’s more by necessity rather than by choice that people take the preferred equity. David Eyzenberg, Eyzenberg & Company

But David Eyzenberg, who runs a boutique advisory firm specializing in debt, equity and ground lease deals, said developers often have to make tough decisions when it comes to financing their projects.

“I have a feeling that it’s more by necessity rather than by choice that people take the preferred equity,” he said.

—Additional reporting by Chava Gourarie

Update: This story was updated to include a statement from Rubenstein and to clarify that Madison’s loan on Eichner’s 45 East 22nd Street project was a first mortgage.