Increased interest rates have created a gap between senior loans and common equity in real estate development capital stacks which is attracting investors to preferred equity transactions offering high returns under certain underwriting and loan to value requirements according to a recent article in Wealth Management. See Investors Eying Real Estate Shift Focus to Preferred Equity Vehicles (wealthmanagement.com).
As an alternative financing structure, preferred equity investments are found in real estate development projects to provide additional funding for pre-development design, permitting, construction, and property expenses. The preferred equity structure is flexible and terms may vary significantly for each transaction which often provide preferred equity investors with a preferred return of 14% to 22% annually with maturity dates for repayment of invested funds and returns.
Although these preferred equity structures are flexible, many transactions have common provisions, including the following:
- Limited Liability Company. Preferred equity transactions use a limited liability company ownership structure where a preferred equity investor is a joint venture member with the developer in a limited liability company operating agreement.
- Management. The developer acts as the managing member of the limited liability company with responsibility for managing the day-to-day activities of the joint venture and the project. The preferred equity investor has approval rights over negotiated major decisions of the joint venture and the project that may materially affect the preferred equity investor’s investment.
- Priority Return. A preferred equity investor’s invested capital and return is repaid prior to the developer’s common equity, but after repayment of the construction loan for the project.
- Removal. If the developer defaults under its obligations in the limited liability company operating agreement, the preferred equity investor may remove the developer as managing member of the joint venture.
- Lender Provisions. The preferred equity investor may negotiate other protections in the joint venture operating agreement customarily found in the loan documents.
We have negotiated many preferred equity joint venture operating agreements for small to middle market development projects including the projects such as construction of single-family homes, multifamily rentals, and mixed-use condominium projects.
Murphy PC is a law firm in Boston, Massachusetts representing, developers, investors, owners, asset managers, and sponsors in all aspects of real estate, including project development, acquisitions and dispositions, joint ventures, capital markets, commercial leasing, design and construction contracts, and title and escrow services. Our real estate capabilities include a variety of sectors and asset classes in small to middle-market segments, including, mixed-use, multi-family, office, retail, and restaurant.