Multifamily Recap with Pref Equity - Valuation/Financing Considerations
Hey All-
I'm thinking through a hypothetical recap for a smaller multifamily deal. Here is an example:
-purchase a messy 50 unit apartment complex for $5mm on a line of credit, 100% LTV
-add $2mm in capex for deferred maintenance and unit renovations (also funded via line of credit)
-stabilize asset, operate for several months with strong financials/occupancy before refinance
-receive appraisal for $9mm (all in basis is $7mm)
-Refi @ 70% LTV, 6.3mm in refinance proceeds
-----this is where I need help-----
In order to retire the line of credit completely ($7mm outstanding vs the $6.3mm refi), I would look to raise an additional 700k in preferred equity. I'm assuming lenders may view pref equity as a form of partial ownership transfer, would this trigger a due on sale clause? Are there other lender considerations for a partial recap of the equity?
I could raise the 700k by 'selling' a 35% ownership stake in the ownership entity at the new $9mm valuation. (9mm-7mm=2mm, 700k/2mm=35%).
Has anyone recapped a deal where the new equity provider was pari passu (no pref or fees etc)? How did you determine a value for the asset? Did the recap occur during a refi or before / after?
Ah, the multifamily recap scenario with preferred equity – a classic move in the real estate playbook, but always a bit of a brain teaser, isn't it? Let's break down your scenario and sprinkle in some insights based on the highest ranked content on WSO.
First off, your approach to purchase, renovate, stabilize, and then refinance is a solid strategy, often referred to in the industry as the "value-add" strategy. It's a tried and true method for increasing the value of an asset through direct improvements and operational efficiencies. Now, onto the nitty-gritty of your question regarding the refinancing and introduction of preferred equity.
Refinancing and Preferred Equity Introduction:
Due on Sale Clause Concerns: Generally, a due on sale clause is triggered when there's a transfer of ownership. However, preferred equity can sometimes be structured in a way that it doesn't trigger this clause. It's crucial to have a clear conversation with your lender about this. Based on the WSO content, lenders' views on preferred equity can vary, but many are open to it as long as it doesn't disrupt their senior position or significantly alter the ownership/control structure in a way that increases their risk.
Lender Considerations: Lenders will scrutinize the deal to ensure that the introduction of preferred equity doesn't jeopardize their loan's position. They'll look at the preferred equity terms, ensuring they're not too aggressive and that the debt service coverage ratio (DSCR) remains healthy post-recap. The key here is transparency and negotiation with the lender to find a structure that works for all parties involved.
Valuation and Ownership Stake Calculation: Your method of calculating the ownership stake for the $700k preferred equity injection is logical. You're essentially offering a piece of the equity based on the post-renovation value minus the all-in cost, which is a common approach. However, remember that the actual percentage and terms can be subject to negotiation based on the perceived risk and return by the preferred equity investor.
Recapitalization with New Equity Provider:
Pari Passu Equity: When new equity comes in on a pari passu basis (meaning on equal footing with existing equity, without preferred returns or fees), it's a bit less common but not unheard of. The valuation for the asset in such scenarios is typically based on its stabilized income and comparable sales, much like how you've approached it. The timing of the recap (during refi or before/after) can vary based on the specific deal dynamics, lender requirements, and the new equity provider's preferences.
Negotiation and Structuring: It's all about finding the right partner who aligns with your vision for the property and negotiating terms that reflect the risk and potential upside. This might involve detailed financial modeling and projections to justify the valuation and the equity split.
In summary, your approach is on the right track. The key is to work closely with your lender to ensure they're comfortable with the introduction of preferred equity and to find an equity partner who shares your vision for the property. Structuring these deals can be complex, and it often comes down to negotiation and alignment of interests among all parties involved. Based on the insights from WSO, it's clear that communication, transparency, and a solid understanding of the financials are critical to successfully navigating a recapitalization scenario like this.
Sources: Investment Sales Vs. Debt/Equity Brokerage, Pros/Cons - Mezzanine Debt vs. Preferred Equity, https://www.wallstreetoasis.com/forum/investment-banking/how-to-prepare-for-restructuring-technical-questions?customgpt=1, From Real Estate Finance to Founder of Development Company - Q&A, Q&A: PE Secondaries Principal
I've worked on quite a few deals with mezz/pref financing, and I'm curious why you'd want to include an extra tranche (and its resultant fees, higher interest, etc) rather than work with the bank to secure a higher LTV loan. In my experience lenders, particularly non-bank, have been willing to take on higher LTV in exchange for a nominally higher DSCR constraint/interest rate if it means simplifying the deal. In this case, 78% LTV on a $9MM appraisal is not out of the question, nor is 70% on a $10MM appraisal. Without knowing more about your situation, it would make most sense in my view to shoot for the middle of the road and ask for 75% on a $9.3MM valuation.
Second, is there a reason why you're allowing the pref to come in pari passu? In that case, while I suppose you can call it pref, it really acts as GP/LP equity and you're taking on a new partner. You can call anything pref equity these days but it really implies that it comes before common equity in the capital stack and offers a (lower) preferred return. When I worked on capital markets sourcing my team commonly interchanged pref and mezz and so did many senior lenders because the most competitive preferred return profiles were similar to mezz lending rates. The distinction really came from 1. what the capital wanted to call themselves and 2. the terms they insisted upon.
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