Fannie Mae published a new equity analysis checklist, Form 6441 (05-26), which is now in effect. What follows is a summary of how to approach the upfront review of an equity structure to determine whether an equity analysis is required and whether the equity structure will be compliant with Fannie Mae requirements. (Note: We have purposefully refrained from using every defined term in the equity analysis checklist in this summary because we think it can make the preliminary vetting of an equity structure somewhat confusing.)

Common Equity

Fannie Mae now requires formalized analysis of common equity structures that have Forced Sale rights or Control Takeover rights. These types of common equity transactions are called Structured Common Equity in the Fannie Mae equity analysis checklist. Fannie Mae had historically wanted lenders to analyze common equity structures when there were Forced Sale rights or Control Takeover rights, but the guidance wasn’t formally published. This resulted in a wide discrepancy among similar structured transactions in how the transactions were reviewed by lenders and lenders’ counsel. The formalized common equity review requirements should bring more uniformity to how common equity structures are evaluated and reviewed, but it will also create some friction for sponsors who may have had noncompliant common equity structures utilized on Fannie Mae transactions.

Fannie Mae has also added specific excluded types of equity structures to the equity analysis. Many common equity joint ventures will have Forced Sale rights or Control Takeover rights, so it is important to identify upfront whether an exclusion applies. The list of excluded equity transactions is as follows:

• Both the sponsor and equity investor are underwritten and named as key principals (and, if applicable, guarantors); for example, a joint venture with a single equity investor where both sponsor and equity investor are fully underwritten.
• An equity structure with multiple equity investors where the owners are simply paid on a priority basis relative to different IRR thresholds with a promote running to the Sponsor. In these types of typical promote structures with many equity investors, none of the equity investors should be a principal and the Forced Sale rights and/or Control Takeover rights should be based on majority vote – that is, no single equity investor can exercise such rights on their own. Many common equity structures will fall under this particular exclusion.
• LIHTC transactions.

The key features to consider for common equity structures that require analysis under the equity analysis checklist are:

• Remedies for a breach under the joint venture agreement (JVA) should be limited to exercise of a Control Take Over, exercise of a Forced Sale or sue for breach of contract under the JVA.
• For crossed equity transactions – one joint venture owns multiple subsidiary SPEs, for example – crossed equity is now permitted if the default triggers in the JVA are limited to the Permitted Equity Default Triggers in Part II of the equity checklist. This is an important change because so long as there are not economic or performance type of trigger events in the JVA (DSC covenants, occupancy covenants), it is likely that the default triggers in the JVA will be limited to the Permitted Equity Default Triggers. As a result, we anticipate more Structured Common Equity transactions may be allowed to be crossed equity.
• For Structured Common Equity, an equity investor’s forced sale and redemption rights can be exercised at any time. This is a departure from past requirements and is significant and will be meaningful in the marketplace.

Preferred Equity

Preferred Equity transactions are equity transactions where the equity investors receive a preferred return relative to other equity investors. Fannie Mae now specifically identifies an equity investor’s receipt of asset management fees ahead of returns to other equity investors.

Historically, we haven’t seen preferred equity transactions structured with asset management fees payable in priority to returns of other equity investors. But we suspect this may have been a workaround among parties to comply with the letter of the Fannie Mae requirements while perhaps inconsistent with the spirit of the Fannie Mae requirements. Fannie Mae, then, has plugged this apparent loophole.

Fannie Mae breaks out preferred equity into three buckets that have different underwriting considerations: Soft Pay Preferred Equity; Mandatory Pay Preferred Equity; and Hard Pay Preferred Equity. Soft Pay Preferred Equity is preferred equity where the payments are only paid out of excess net cash flow. Mandatory Pay Preferred Equity is a structure where the failure to receive a preferred equity return can result in a forced sale remedy. Hard Pay Preferred Equity is a structure where the failure to receive a preferred equity return can result in Control Takeover for the equity investor. This distinction makes the Mandatory Pay Preferred Equity bucket in line with an underwriting LTV/DSCR with Freddie Mac’s treatment of hard pay preferred equity.

In considering whether the equity analysis checklist must be completed for a preferred equity structure, Fannie Mae now specifically excludes several types of structures (in addition to the examples of excluded structures we noted for Structured Common Equity):

• REIT structures where investors are paid from net cash flow
• Promote structures where investors are paid priority cash flows upon the achievement of different IRR levels. Many equity structures that may look like preferred equity structures are actually promote structures, so many of these equity structures will fall into this exclusion.

Certain types of transactions are not eligible to have preferred equity that requires compliance with the equity analysis checklist:

• Small mortgage loans
• Senior housing properties
• Student housing properties
• Cooperative properties
• Manufactured housing communities
• Credit facilities
• Adjustable-rate mortgage loans
• Assumptions
• Any loan where the exercise of Control Take Over rights would result in the Fannie Mae loan being classified as a conflicts loan

There are several key features to consider for preferred equity structures that require analysis under the equity analysis checklist:

• The default triggers under the JVA must be limited to the Permitted Equity Default Triggers identified in Part II of the equity analysis checklist.
• Remedies for a breach under the JVA should be limited to exercise of a Control Take Over, exercise of a Forced Sale, sue for breach of contract under the JVA, increase of a default rate on equity investor’s preferred return and the right to remove the affiliated property manager. Note that a de-equitization type of remedy is expressly not permitted, i.e., a forced sale to an affiliate at less than fair market value.
• Redemption rights of the equity investor and forced sale rights of the equity investor should be limited to after the earlier of the yield maintenance period of the Fannie Mae loan or the fifth-year anniversary of the Fannie Mae loan. Note that a redemption or buy-sell right within the mortgage loan term requires additional MBS disclosure.
• Cash reserves or interest reserves to pay the preferred return are not allowed.
• Pledges of equity are not allowed.
• The preferred equity must be fully funded at origination of the Fannie Mae loan.
• For crossed equity transactions – one joint venture owns multiple subsidiary SPEs, for example – crossed equity is now permitted if the default triggers in the JVA are limited to the fraud, gross negligence or willful misconduct of the sponsor. This is an important change because some preferred equity investors will accept this very limited cross default trigger in a crossed equity transaction, so some crossed equity preferred equity transactions that previously did not qualify for Fannie Mae financing will now be eligible.
• There must be no financial/economic type of covenants, other than a requirement to pay a hard preferred equity payment.

Special Items to Note

• For Structured Common Equity and Soft Pay Preferred Equity, if the equity investor only has a forced sale right, then the equity investor is just underwritten as a principal using standard underwriting requirements.
• For Structured Common Equity and Soft Pay Preferred Equity, if the equity investor has redemption or buy-sell rights within the Fannie Mae loan term, the equity investor must be underwritten as a principal with the additional principal due diligence requirements (mortgage credit analysis that, at minimum, includes obtaining financial statements, an SREO schedule and Form 6460s).
• For Structured Common Equity and Soft Pay Preferred Equity, if the equity investor has control take over rights triggered upon bad acts, a mortgage loan default or the sponsor taking action without the consent of the equity investor, then the equity investor must be underwritten as a principal with the additional principal due diligence requirements (mortgage credit analysis that, at minimum, includes obtaining financial statements, an SREO schedule and Form 6460s).
• For Structured Common Equity and Soft Pay Preferred Equity, if the equity investor has control take over rights triggered upon the Permitted Equity Default Triggers other than the three triggers noted above, then the equity investor must be underwritten as a principal.
• For Mandatory Pay Preferred Equity, the equity investor must be underwritten as a principal with the additional principal due diligence requirements noted above.
• For Hard Pay Preferred Equity, the equity investor must be underwritten as a principal with the additional principal due diligence requirements noted above and the equity investor must satisfy the Fannie Mae experience requirements (25,000 units under management).
• Note there are different combined underwriting LTV and DSCR requirements for Mandatory Pay Preferred Equity (90% LTV and 1:1.05 DSCR) and Hard Pay Preferred Equity (85% LTV/1:1.10 DSCR).
• There are no special loan sizing requirements for Structured Common Equity or Soft Pay Preferred Equity.
• Fannie Mae pre-review is required for all Mandatory Pay Preferred Equity, Hard Pay Preferred Equity, and Soft Pay Preferred Equity and Structured Common Equity that has non-compliant features.
• Mandatory Pay Preferred Equity and Hard Pay Preferred Equity have additional MBS disclosure requirements.

Miles & Stockbridge’s multifamily housing finance lawyers are available to address any questions you may have about the new equity analysis checklist.

Related Documents

PE checklist

PE rider to the loan agreement

PE addenda to Schedule 2 to the loan agreement

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.