It's no secret that the rapid increase in interest rates over the past year has resulted in an extremely challenged CRE lending environment. Other factors contributing to this challenging landscape include: (i) a meaningful decline in deposits at regional banks (who make up a disproportionate share of commercial real estate (“CRE”) lenders); (ii) an anticipated decline in CRE property values; and (iii) CRE lenders tightening their lending standards. As a result, Borrowers attempting to obtain “plain vanilla” acquisition financing are finding a dearth of options. Even where a borrower secures a commitment for traditional financing, the higher interest rates, tight covenants, and onerous reserve, deposit and guaranty requirements often make such debt unattractive. Despite these headwinds, CRE investors still have billions in dry powder for new transactions—so where do CRE investors turn?
Sophisticated multi-family investors looking to complete their capital stacks are increasingly turning to the assumption of existing Freddie Mac senior mortgage debt (“Freddie Debt”) and stapling it with an infusion of preferred equity. The assumption of existing Freddie Debt is extremely attractive, because such debt is typically “fixed rate” paper with an interest rate that is several hundred basis points below the rates on new “floating rate” mortgage loans. Typically, the assumed Freddie Debt has a maturity date occurring at least 24 to 48 months following the expected closing date. Essentially, CRE investors are gambling that in several years’ time interest rates will be lower and the capital market will have normalized, which will facilitate either a refinancing opportunity, sale or other exit event.
While the assumption of Freddie Debt is a “no-brainer” from a financial standpoint, there are several factors that make such assumptions a more involved process—one that should not be undertaken blindly. First, certain sellers may not entertain an assumption because of the increased complexity and longer time periods required, but given the current state of the debt markets, many initially reluctant sellers (particularly those who desire a near term liquidity event) may now view such assumptions in a more positive light. Second, because Freddie Debt has lower loan-to-value requirements than other mortgage debt (and the debt itself may have been paid down over time), CRE investors either must provide more equity than typically required or they must turn secondary financing sources (such as preferred equity or other subordinate debt).1Third, Freddie Mac consent is often required for such assumptions (particularly those involving a fresh infusion of preferred equity). Fourth, there is often a predetermined assumption fee payable in connection with the same as well as increased legal costs. Fifth, where such consent is granted, Freddie Mac will generally not approve any amendments or modifications to the existing Freddie Debt (other than necessary factual modifications regarding borrower and guarantor names, etc.)—nor will Freddie Mac enter into any form of recognition agreement (regarding preferred equity) or intercreditor agreement regarding subordinate debt. Sixth, Freddie Mac has a very specific “box” in which it is willing to approve preferred equity and the restrictions are material and should be explained in detail to prospective preferred equity investors in advance of the commencement of material work on the transaction. Seventh, due to Freddie Mac’s requirements, assumptions coupled with preferred equity have a slightly greater risk profile than traditional preferred equity or mezzanine financing and therefore the cost of such capital is typically higher as a result. Finally, the approval process (which involves an in-depth review of the operating agreement governing the terms of the preferred equity investment (the “JV Agreement”) for compliance with the Freddie Mac approved “box”) can take at least 30 days to complete, but typically takes closer to 60-90 days.
Types of Preferred Equity / Defining the “Box”
As described above, Freddie Mac has detailed and rigid requirements with respect to preferred equity. Historically, Freddie Mac characterized preferred equity into two distinct buckets: (i) “soft” preferred equity (“Soft Pref”) and (ii) “hard” preferred equity (“Hard Pref”). However, in the most recent Multifamily Seller/Servicer Guide, dated April 13, 2023 (the “Guide”), Freddie Mac dropped the Soft Pref and Hard Pref terminology and opted (despite the characteristics of Hard Pref and Soft Pref remaining unchanged) to redefine Soft Pref as “Common Equity” and Hard Pref as “Preferred Equity”. Therefore, in this article Soft Pref is referred to as Common Equity and Hard Pref is referred to as Preferred Equity.
Whether an equity investment is classified as Preferred Equity or Common Equity is extremely consequential. While there is a potential path to obtaining Freddie Mac approval for Preferred Equity, obtaining such approval in an assumption is extremely rare (and is subject to a longer and more complicated approval process). As a result, most CRE investors (and sellers) are not willing to spend the time, effort or money pursing a transaction where Freddie Mac’s consent is unlikely. Therefore, nearly all equity investors pursue Freddie Debt assumptions that are combined with Common Equity (i.e., Soft Pref). A description of the differences between Common Equity and Preferred Equity is below.
In the context of preferred equity, at its most basic, “Common Equity” is a form of investment in an entity where the equity investor is entitled to receive preferred distributions, payments or returns only out of net cash flow from the Property (i.e., cash flow, if any, available after payment of all operating expenses for the Property, lender’s debt service and any escrows and reserves required by the lender) before any other investor receives any distributions, payments or returns). However, it is more instructive to define Common Equity by what it is not—Common Equity must also not have any of the characteristics of Preferred Equity. If an equity investment has any of the characteristics of Preferred Equity, it is deemed to be Preferred Equity.
“Preferred Equity” is any investment in an entity where the equity investor is entitled to receive periodic distributions, payments or returns (e.g., monthly, quarterly, annually or other set period), that have priority over distributions, payments or returns to any other equity owner, whether or not there is sufficient net cash flow from the Property (sometimes referred to as a “hard pay” structure) (a “Preferred Equity Return”). However, any equity investment is also considered Preferred Equity by Freddie Mac if it has any of the following characteristics:
- The equity contribution and/or any accrued Preferred Equity Return must be paid on a set date, or the underlying real property (the “Property”) is subject to a predetermined date of sale or other disposition; and
- Other than (i) the right to force a sale of the Property upon a default under the JV Agreement or (ii) enforcement of remedies regarding true bad boy events, the equity investor has default rights or remedies if (x) not paid the Preferred Equity Return or all or any part of its equity contribution, or (y) due to the failure of any other economic performance measure (such as debt service coverage ratios, LTVs other similar metrics).
Moreover, Freddie Mac will not approve of a Preferred Equity or Common Equity structure that contains any of the following attributes, except in limited circumstances:
- The equity contribution or Preferred Equity Return must be paid on a date prior to the maturity date of the Freddie Debt;
- The equity investment is not fully funded on the date of the assumption (e.g., there is a draw, holdback or other phased funding component);
- Any of the obligations related to the equity investment are secured by any form of collateral, including, but not limited to, any pledges of equity, liens on the Property on any other real or personal property, or reserves that can be swept by the equity investor or have characteristics similar to collateral);2
- An intercreditor agreement, subordination agreement, recognition agreement, or any other agreement with the Property lender (i.e., the lender of the Freddie Debt) is required to limit or delay such lender’s rights or remedies;
- The terms of the equity investment permit any payment to an equity investor before payment of operating expenses of the Property and all sums then due to the lender under the Freddie Debt documents;
- Except with respect to true bad boy events, the equity investor has the right under the JV Agreement to remove or replace the person or entity with direct or indirect control of the senior mortgage borrower based on the actions or inactions of any person or entity other than the Borrower or an entity in the Borrower’s ownership structure;
- The right to exercise a control takeover of the Borrower based on the Property’s failure to achieve specific, quantifiable occupancy, net operating income, debt service or other economic performance measures while the Property is performing under the Freddie Debt;
- The equity investment is cross-defaulted or cross-collateralized with any other agreement not related to the underlying Property or the equity investor is entitled to exercise remedies with respect to the economic performance of any other real property other than the Property (unless Freddie Mac also has a mortgage on the other real property which mortgage is cross-collateralized and cross-defaulted with Freddie Mac’s mortgage on the Property);
- The equity investor has the right to make additional capital contributions or protective advances that increase the size of its equity investment for any reason other than to pay debt service, taxes, or insurance (or other similar and narrowly defined non-discretionary expenses);
- A cash sweep at the Property level exists for any default under the JV Agreement;
- There is an assignment of any cash reserves at the Property level, except reserves established solely from the proceeds of the equity contribution;
- The equity investor or its assignee(s) has the right to acquire the equity interests of (i) the person or entity with direct or indirect control of the borrower or (ii) any other equity owner, without purchasing those interests for fair market value;
- There are any additional terms and requirements regarding the equity investment not included in the JV Agreement, bad boy guaranty and/or customary environmental indemnity that circumvent the Common Equity requirements (i.e., there may not be any “off the record” side letters);
- The guarantor executing a guaranty in connection with the equity investment is the same guarantor providing a guaranty with respect to the Freddie Debt (a “Common Guarantor”), unless the payment obligations under the equity guaranty are fully subordinated to the Freddie Debt;
- If there is a Common Guarantor, the guaranteed obligations re the equity investment must be substantially similar to the guaranteed obligations under the Freddie Debt guaranty; or
- The equity guaranty has any of the unacceptable guaranty trigger events.3
Complicating matters further, in Common Equity deals, Freddie Mac will permit what is defined as a “Preferred Equity Control Take Over Transfer” in its form Loan Agreement, giving an equity investor named in the Loan Agreement (and underwritten in advance by Freddie Mac) the right to take over control rights of the Borrower pursuant to certain terms and conditions. The named equity investor is referred to in the Loan Agreement as the “Preferred Equity Investor,” but inclusion of this provision in Common Equity deals does not trigger the Preferred Equity analysis. Freddie Mac will also permit, in Common Equity deals, what is defined as a “Buy-Sell Transfer” in its form Loan Agreement, giving an equity investor the right to take over control rights of the Borrower and/or force a sale of the managing member’s ownership interests in the Borrower pursuant to certain terms and conditions. Again, the “Buy-Sell Equity Investor” must be named in the Loan Agreement and underwritten in advance. The foregoing options provide some flexibility for common joint venture remedies in the Common Equity structure, but the available remedies are more limited than in a traditional preferred equity arrangement.
As is clear from the descriptions of Preferred Equity and Common Equity above, an equity investment must be highly structured to satisfy the Common Equity requirements. Additionally, while the Common Equity and Preferred Equity requirements noted above (and in the Guide) are instructive, there is quite a bit of nuance and interpretation in the characteristics of such terms (especially when compared to what Freddie Mac will actually approve). It is therefore critical to involve experienced legal counsel early in the process (preferably when drafting the term sheet) to set the stage for a successful transaction. Many equity investors who are not familiar with the Freddie Mac requirements find them more burdensome than expected and setting expectations in the term sheet will lead to a more efficient process. Employing skilled and experienced counsel that understands the nuances that Freddie Mac is looking for in the JV Agreement and other constituent investment documents will ensure the assumption will not be delayed (or rejected entirely). While the assumption of Freddie Debt coupled with Common Equity is no doubt a more complicated transaction, CRE investors looking to deploy capital in the near term are increasingly turning to such transactions because of the challenging state of the capital markets. The capital markets will undoubtedly take time to adjust to the seismic shift in interest rates and general CRE market conditions and securing traditional acquisition financing during such adjustment period will continue to prove challenging. As a result, we expect to see a greater number of Freddie Debt and Common Equity transactions over the next 12-18 months as CRE investors look for alternative means to deploy capital.