The Rise of Rescue Capital

The dramatic rise in interest rates continues to reverberate through the real estate market. As a result, strategies that made sense two or three years ago may not in the current market. On the other hand, some strategies that were less appealing to us in recent years are now quite compelling. Enter preferred equity.

Preferred equity sits between debt and equity on the capital stack, meaning it is paid back after debt, though prior to equity investors. As such, projected risk and returns usually fall somewhere between debt and equity. 

For most of the last decade, which has been characterized by strong market fundamentals and abnormally low interest rates, common equity holders have been richly rewarded for any additional risk taken. Annual returns of over 20% have been common-place. The upside was too good to pass up.   

The rapid rise of interest rates has since thrown cold water on the market, leading to declining prices in most asset classes. This has knocked common equity investors' return-expectations down a notch or two and losses and cash calls are becoming more common. The current economic climate also makes it much more difficult to decide what to do next. 

Preferred equity presents a compelling option if you believe medium-term growth for real estate assets will be more moderate and a collapse from today’s prices is unlikely. This scenario could produce equity-like returns for preferred equity investors without equity-sized risk. 

One place we are seeing preferred equity opportunities is in the US Multifamily market. Particularly with properties purchased within the last two years using bridge financing, which has been commonplace. For many multifamily investors, their intended strategy when they purchased the property was to increase net operating income and then refinance at lower interest rates, anticipating that they would achieve long-term financing between 70% and 80% loan to value (LTV). 

Due to falling values and increasing lender caution however, many borrowers have only been able to refinance between 50% and 60% LTV, leaving a gap in their capital stack. This creates an opportunity for preferred equity investors to provide an additional 10-20% of the capital stack, while still having substantial common equity behind them. 

There are numerous properties that will need to refinance in the coming quarters, and many see preferred equity as a natural solution to plug the gap. Current demand for preferred equity puts investors in the driver's seat to negotiate terms, and can often demand 12-14% returns, which we believe are quite attractive in the current environment.

While we don’t have any current opportunities in preferred equity, we are exploring options. We look forward to discussing this strategy further should a deal present itself. As always, if you have any questions or there’s anything we can do to help, please don’t hesitate to reach out.