Accrual-heavy pref or cash-pay pref when the property can only carry one of them

Question

I'm looking at a 180-unit garden deal where the senior is sized to a 1.20x coverage on its own and the sponsor needs another 4.5 million to close the refi gap. The old mortgage was around 4.6 percent, the new quote is north of 6, so the gap is real and the pref is the only thing filling it.

Two ways to write it. Version one is 11 percent all current, paid monthly, and the property pays it out of operations from month one. That means I'm collecting cash and I know within 30 days if the deal is sick. It also means the combined coverage drops under 1.0x on day one and the sponsor funds a reserve to bridge it, which is really me lending myself my own coupon for two years.

Version two is 5 percent current, 8 percent accrued and compounding, with a 1.35x minimum multiple at exit or redemption. The property can actually carry the 5. My total dollars are higher if it works. But I find out nothing for three years, and by the time I find out, the accrued balance has grown past what the asset can support and my only real remedy is a sale into whatever market exists then.

The argument for current pay is information. The argument for accrual is that a pref that strangles the property in year one produces a default I don't want to own, given I have no lien and I sit behind the senior.

I genuinely go back and forth on this depending on the day and the sponsor.

wendy_park48 · Answer

The thing that decides it for me isn't the coupon split, it's what the accrual does to my remedies. Read the redemption waterfall on version two and check whether accrued-but-unpaid pref counts toward the events that let you act. I've seen docs where the trigger is a missed current payment only, so a position that accrues 8 percent for three years and blows through the value of the asset never technically produces a default at all. You sit there fully performing on paper while your recovery evaporates.

Also check whether the accrual compounds on the accrued portion or only on the original balance. Difference on 4.5 million over three years is not small and I've read term sheets where the word "compounding" appeared in the summary and nowhere in the operating agreement.

If version two gives you a hard outside redemption date, a real financial covenant on combined coverage, and accrual counts toward your triggers, I'd take it. Without those three things the accrual structure is just a longer blindfold.

tonyv88 · Answer

The reserve in version one worries me more than the coverage number does. I've managed assets where a two-year reserve funded the pref coupon and the ops team treated that money as a cushion for everything else, so unit turns got deferred and by month 20 the rent roll couldn't support the payment the reserve had been faking. If you go current pay with a reserve, ring-fence it and get monthly reporting on what's left in it. Otherwise you're buying the appearance of information.

Accrual-heavy pref or cash-pay pref when the property can only carry one of them

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