United States: Preferred Equity Investments And Mortgage Lending: Issues For Lenders And Borrowers

Last Updated: April 22 2015
Article by David Brier

Real estate owners and developers have been increasingly turning toward preferred equity structures and investments in order to raise much needed capital for the purchase, renovation, and development of real property where such capital is unavailable from traditional lending sources. Historically, these shortfalls in capital were often funded through subordinate and mezzanine financing. One reason for the increase in preferred equity investments is likely due to the distaste of some mortgage lenders in making mortgage loans where there is or will be subordinate or mezzanine financing in place. However, preferred equity investments are often structured essentially as disguised mezzanine and subordinate financing wherein the third-party investor is promised a certain return on its investment and granted remedies, much like a secured lender, in the event the investment is not repaid in a specified period of time.

Accordingly, these investments raise many of the same issues and pitfalls for lenders as mezzanine and subordinate financings would, including potential transfers of management and controlling interests in their borrower as well as a decrease in the economic resources being available for the property and repayment of their loan. Lenders have responded to these concerns by tightening their loan documents and underwriting standards to limit and identify these structures. However, because preferred equity investments come in many shapes and sizes, there is no "one-size-fits-all" solution available to lenders. Further, borrowers often turn to preferred equity investments late in a transaction when lender underwriting of the borrower and the transaction has already been completed, which inevitably leads to delays in closing and frustration by all parties. This article will briefly discuss some of the problems and challenges to lenders and borrowers raised by these investment structures and some of the ways in which lenders and borrowers have attempted to address these issues.

How Are Preferred Equity Investments Structured?

Preferred equity investments in real estate transactions come in various forms and, unlike subordinate or mezzanine loans, are typically documented in the borrower's organizational documents. Generally, the deals are structured as an investment by a third-party investor in the real estate owner or various affiliates in the chain of ownership in exchange for a direct or indirect ownership interest in the real estate owner entitling it to a preferred/priority return on its investment. Sometimes, the preferred equity investment is structured much like a loan where (i) "interest" on the investment is required to be paid monthly by the "borrower" regardless of available property cash flow; (ii) the entire investment is required to be paid by a certain maturity date; (iii) default rate "interest" and penalties are assessed against the "borrower" in the event payments are not made timely; and (iv) a default in the repayment of investment potentially results in the loss of management and/or ownership control by the "borrower" in the company in favor of the investor or other third-party. This type of structure is generally known as a "hard" preferred equity structure and presents the most problems for a lender. Often, this type of structure will require the lender to underwrite the loan much as it would a subordinate or mezzanine loan, and will require the investor to enter into direct negotiations with the lender (much like a mezzanine borrower would negotiate an intercreditor agreement with a senior lender) to ensure that its payment requirements and enforcement rights do not trigger a default under the senior loan. Further, "hard" preferred equity structures often require that the lender underwrite the proposed investor, a process that is both time consuming and labor intensive and could potentially significantly delay the closing of a transaction.

Alternatively, a "soft" preferred equity structure combines elements of the above, but (i) may not require payments of "interest" to be made on the investment unless the property is generating sufficient excess cash flow (after payment of debt service on the senior loan and property operating expenses); (ii) may not have a set maturity date or absolute payment obligation; and (iii) may eliminate some or all of the harsher remedies in the event the investment is not paid back timely. Generally, these investments, which more closely resemble a typical joint venture type agreement between partners, are more acceptable to a lender in that they present less or no interference with the management and cash flow from the property. Adding to the dilemma facing a lender is the fact that because preferred equity investments come in many forms, unlike subordinate or mezzanine financing, it may not be as readily apparent to the lender what type of preferred equity investment is being used for a proposed transaction without a thorough and careful examination of the borrower's organizational documents, something a lender is generally reluctant do in the underwriting stage of the loan. Such analysis is further complicated by the fact that borrowers may not finalize a deal with their investors until the transaction is almost ready to close.

Lenders' Response

Lenders have responded to the prevalent use of preferred equity structures in two primary ways. First, in the underwriting stages of the loan, lenders have tightened their underwriting standards and are now requiring borrowers to make clear what type of preferred equity structure is contemplated as being utilized. This underwriting requirement puts pressure on borrowers to finalize their deals with their investors earlier than they might have done in the past. Both Freddie Mac and Fannie Mae require multifamily lenders to cause all borrowers to complete, prior to loan approval, detailed analyses of any preferred equity structures to determine whether a "soft" or "hard" preferred equity structure is contemplated. The detailed checklists required by Freddie Mac and Fannie Mae are designed to determine and classify what type of preferred equity is being considered. The analysis of this information often involves the utilization of the lender's legal counsel at an early stage of the loan in order to ensure that the lender understands the type of preferred equity being proposed, and in order to address any of the issues that may be raised by the use of such structure.

Second, lenders have responded by beefing up their loan documents to prohibit the use of preferred equity investments, much like the traditional provisions in loan documents that prohibit secondary or subordinate financing. Once again, the devil is in the details, and lenders need to make sure that their language is not overly restrictive so as to prohibit ordinary joint venture type investments that should present no issues to a senior lender.

Borrowers Beware

Similarly, borrowers need to read these provisions very carefully to make sure that their proposed structures do not violate these agreements since these provisions are often drafted so broadly so as to prohibit almost any type of thirdparty investment no matter how far down the ownership chain the investment occurs and no matter how "soft" the contemplated preferred equity investment is intended to be. To make matters worse, violations of these provisions are very often classified as prohibited transfers under the loan documents, which could result in recourse liability to the borrower and any guarantor of the loan. Accordingly, it is crucial for borrowers to understand the provisions and restrictions contained in the loan documents to make sure they are not inadvertently violated.

Key Takeaways for Lenders and Borrowers

Preferred equity investments are here to stay and will play an important role in filling the gap that may be left by traditional financing. It is important for borrowers and lenders to understand that preferred equity structures can often result in issues for lenders and borrowers in real estate financing transactions. Lenders need to understand what type of preferred equity is being contemplated by the borrower early on in their underwriting of a loan in order to evaluate any potential legal or underwriting issues raised by the proposed structure. Borrowers need to disclose and finalize their deals with their investors early on in the underwriting process to ensure that their lenders are able to address any concerns of the investors and issues raised by the proposed structure. Finally, borrowers need to carefully scrutinize the loan documents to determine that the proposed preferred equity structure will not violate the terms of their loan documents.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions