As the multifamily boom ran into pandemic delays, cost overruns and now a brutal refinancing environment, developers with new projects have fires to put out.
Many have looked to raise money through capital calls or attempted to renegotiate with their lenders. With those options exhausted, some have turned to investors for a lifeline in the form of preferred equity.
This so-called rescue capital — often provided by other developers or lenders moving up the capital stack — is stepping in to get stalled projects delivered to safety.
Brian Cornell, who runs deals for the investment arm of brokerage Walker & Dunlop, said he’s seeing projects where construction is complete and leasing needs to get done, but the borrowers are having trouble refinancing their loans.
“Those borrowers are having trouble doing that without preferred equity or capital calls,” he said.
Multifamily projects, many concentrated in the high-growth Sun Belt states, got hit with delays and cost overruns as the price of materials like timber soared.
Compounding this are challenges on the financing side. Interest rate caps have become exorbitantly expensive, and, as they expire, borrowers are facing steep costs trying to purchase new ones. And the general high-rate environment makes refinancing a construction loan difficult.
“First, it was the pandemic — everything got delayed, which wiped out a lot of promotes,” said RXR’s Scott Rechler, noting that many of these developers are merchant builders who planned to sell after completing their projects anyway.
“With the interest rate rise, and construction costs rising, they didn’t account for having to put interest rate reserves or the cost of interest-rate caps that have gone up almost 10, 20 times what they originally forecasted. It’s thrown their loans out of balance.”
Calculated risk
Many projects in need of a rescue are fundamentally sound, with cash flowing and some meat on the bone left for investors.
A capital injection can help salvage the sponsor’s economic stake in a deal — the promote — but it does come with some trade-offs. The developer is essentially selling off a piece of its profit to the preferred equity investor, which then steps ahead in line to get paid first.
For the rescue provider, the preferred equity position offers a mix of security and upside.
“You’re going to have the certainty of debt and you’re going to get all the benefits of equity,” said Josh Becker, a tax attorney in the law firm Pillsbury’s New York office.
The deal requires a restructuring of the capital stack and a new joint-venture agreement. For instance, a sponsor normally gets paid via carried interest, which is taxed at the lower capital gains rate. But after taking on preferred equity, the accounting can shift so that the payment is considered ordinary income, which is taxed at a higher rate.
“Developers acknowledge that it causes additional risk. If they believe in the value the project will return,
they’re willing to make that trade.”Brian Cornell, Walker & Dunlop
The sponsor also normally gets some allocation of the real estate’s depreciation to help offset taxes. Some of that benefit may be shifted toward the rescue capital investor.
And while the new financing can solve a lot of problems, there are risks. One is that a situation may occur where the interests of the original sponsor and the new investor aren’t aligned.
Becker said, for instance, that the preferred equity investor may negotiate the right to make a ruling on future refinancing decisions. If rates move down, the sponsor may want to refinance the preferred equity position out of the deal at a lower cost. The rescue investor, though, may want to keep its money in place and block such a move.
The deals are highly negotiated and depend largely on relationships and the economics of the project. Generally, the bind for developers is that if they’re looking for rescue financing they’ve got little, pardon the pun, leverage.
“I wouldn’t say the balance of power is entirely in the hands of the rescue capital provider,” Becker said. “But there is a reason why they’re in this situation.”
Cornell said that his firm, which has two preferred equity funds it’s investing through, is only looking to get involved in deals where there’s enough value left to make everyone comfortable sharing the profits.
But he recognized that it can be a tricky situation for sponsors, which are giving up a piece of their shrinking pie.
“I think a lot of developers acknowledge that it causes additional risk to their equity,” Cornell said. “If they ultimately believe in the value the project will return, they’re willing to make that trade.”
Rescue investors are also looking at office deals that fit the same mold of fundamentally sound investments in need of an extra shot in the arm to get on firm ground. Borrowing an analogy, Rechler refers to these as “digital” buildings as opposed to outdated “film” offices.
Despite the stigma around office buildings, he said that RXR is looking at providing preferred equity to properties that have a viable future if they can just get some new capital for things like renovations and leasing.
He’s also got rescue capital lined up for three multifamily deals in Sun Belt markets. But for all the talk of deep-pocketed saviors stepping up, Rechler said he’s not seeing much competition when seeking deals.
“There are a lot of people out there talking about it, but I haven’t found it to be that competitive,” he said, adding that it helps to have your own development expertise to lend. “It’s not something that’s easily marketable. You have to lean into relationships and it’s not just about capital.”