Choosing accrual-heavy versus cash-pay preferred equity when the property can only carry one

Question

Consider 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, with the old mortgage around 4.6 percent and the new quote north of 6. Preferred equity is the piece filling that gap, and it can be written two ways. Version one is 11 percent all current, paid monthly, with the property paying it out of operations from month one. That means cash collection and a signal within 30 days if the deal is sick, but it also drops combined coverage under 1.0x on day one, forcing the sponsor to fund a reserve to bridge it, which is effectively lending against a coupon the deal cannot yet support. 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 percent on its own, and total dollars are higher if the deal works. The tradeoff is going three years without a clear read on the deal's health, and by the time a problem surfaces, the accrued balance may have grown past what the asset can support, leaving a sale into whatever market exists as the main remedy. The case for current pay is information. The case for accrual is that a pref that strangles the property in year one produces a default nobody wants to own, especially sitting behind the senior with no lien. Which version wins tends to depend on the sponsor's track record and how much the investor is willing to trade early visibility for total return.

wendy_park48 · Answer

What decides it isn't the coupon split, it's what the accrual does to remedies. Read the redemption waterfall on the accrual-heavy version and check whether accrued-but-unpaid pref counts toward the events that let a holder act. Some docs trigger only on a missed current payment, 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. The holder sits fully performing on paper while recovery evaporates. Also check whether the accrual compounds on the accrued portion or only on the original balance. On 4.5 million over three years that difference is not small, and term sheets sometimes use the word compounding in the summary and nowhere in the operating agreement. If the accrual version carries a hard outside redemption date, a real financial covenant on combined coverage, and accrual counts toward the triggers, that's a structure worth taking. Without those three things it's just a longer blindfold.

tonyv88 · Answer

The reserve in version one is the bigger worry, more than the coverage number. A two-year reserve funding the pref coupon is a common setup, and the failure mode is well documented: the ops team treats that money as a cushion for everything else, so unit turns get deferred, and by month 20 the rent roll can't support the payment the reserve had been masking. 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.

Choosing accrual-heavy versus cash-pay preferred equity when the property can only carry one

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