Real estate investors and developers, often referred to as sponsors, can increase project leverage by raising various forms of subordinate or gap financing. This type of financing “fills the gap” between the senior debt and the sponsor’s equity and can be structured by any one or more of the ways:
|1. Mezzanine Loan:||In lieu of granting the lender a mortgage, a sponsor can pledge his/her membership interest in the borrowing entity to secure repayment of a mezzanine loan. If the sponsor defaults, the lender can seize the sponsor’s pledged common interests by instituting a forfeiture action via a UCC-1 secured sale.|
|2. Preferred Equity:||Often, senior lenders may preclude the use of subordinate debt – such as mezzanine financing. In such a case, the sponsor will need to raise preferred equity through the sponsor’s entity. By implementing an A/B waterfall structure, the sponsor’s entity can issue senior Class A preferred to the preferred equity investor and subordinate Class B preferred to the sponsor.|
|3. Co-GP Capital:||If a sponsor needs or would like to maximize project leverage, the sponsor can raise co-GP capital by having the sponsor’s entity issue one or more additional classes of preferred. In this case, the preferred equity investor would receive the Class A preferred, the co-GP investor would receive Class B preferred, and the sponsor would receive the first-loss Class C preferred.|
The below capital stack illustration shows the relative risk and return of each level of capital invested in a sponsor’s project. The senior debt has with the highest priority of repayment with the lowest expected return followed by the holder of the mezzanine loan and then the owners of the project equity. With respect to the equity investors, all distributable cash flow will be paid first to the preferred equity investor and then the sponsor. If a sponsor seeks to raise co-GP capital as a way to minimize his/her investment, the co-GP investor would be paid after the preferred equity investor but typically before the sponsor.
Compared with senior debt financing, preferred equity/co-GP capital is the least understood layer of commercial real estate financing and the most difficult to raise in a property’s capital stack. Many of the investors are “under the radar” with the terms, conditions and covenants varying widely. Work with us and we’ll help you navigate the various types of gap financing based on your specific situation. Our execution skills allow sponsors to meet their needs for complex capital raises.