Sometimes, real estate loans need a little sweetening to make them more palatable. To that end, we discuss what is an equity kicker (EK) and contrast it to an equity warrant. Then, we’ll see how to calculate a loan with an equity kicker and give a useful example. Furthermore, we’ll evaluate whether you should sign a loan with an equity kicker and how Assets America® can help. Finally, we’ll finish by answering a few frequently asked questions about equity kickers.
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What is an Equity Kicker?
An equity kicker is an equity (ownership) instrument that adds value to debt. The kicker (the incentive) might be an option, warrant, right, or related feature. An EK adds an expense the borrower must pay in order to receive a loan approval. In other words, you can add in an EK when you want to cinch the deal. Generally, an EK gives you the option to buy shares of the debt issuer. When attached to a mortgage, an EK can be an ownership stake in a property’s cash flows. That is, some EKs involve revenue sharing. For example, an EK might be an equity participation in revenues of a rental or retail property.
Think of an EK as an additional incentive that boosts the lender’s return on investment. Generally, you can use them with real estate loans as well as bonds and preferred shares. Specifically, the EK resides within the debt and gives investors equity rights. Clearly, this provides investors with the opportunity to receive the benefit from an increase in equity value.
Convertible Equity Kickers
When dealing with bonds, including real estate and municipal bonds, an equity kicker is usually a warrant or convertible feature. We’ll describe equity warrants in the next section, but convertible EKs allow you to exchange bonds for stock shares. Importantly, you’ll also see convertible EKs in management buyouts, leveraged buyouts, and equity recapitalizations. Convertible EKs reduce the risk to investors and might allow borrowers to save a few basis points on debt interest.
Equity Warrants vs Equity Kickers
A warrant is like a long-term call option. It gives you the right, but not obligation, to buy shares at a specified price (the strike price). When a warrant is in-the-money, its strike price is below the price or value of the shares.
An equity warrant is one type of equity kicker. Another EK type is convertible preferred stock. This is preferred stock that you can exchange for common stock. You receive the convertible preferred shares along with the bonds you buy.
A rights offering is a type of EK similar to equity warrants. It gives investors a security that we call a “right” and is similar to a warrant. The right allows you to buy shares at a specified discount on a specified execution date. Also, you can trade rights just like you trade shares up until the execution date.
Equity warrants are dilutive, in that they create more ownership participation that must share earnings.
Real Estate Equity Kickers
In real estate, an EK may give you a share of the property’s income or gross rental receipts. You must be careful using real estate with this type of EK, as it is illegal in some jurisdictions.
More often, a real estate equity warrant gives investors a piece of equity in a real estate project. It is often part of a mezzanine loan when borrowers don’t want to pay an extremely high interest rate. That is, the lender/investor may agree to reduce the interest rate in order to receive equity in the property. Normally, the sale of the property triggers this kind of EK.
Often, mezzanine lenders package put options with equity warrants. The put option gives the lender the right to sell the warrants to the borrower at a specified strike. Note that you can exercise the put until the warrants mature. In return, the borrowers get a call option to repurchase the warrants at a specified price after the put expires. These options specify in advance the range of returns available to lenders and the costs to the borrower.
How to Calculate an Equity Kicker
There are different ways to calculate an equity kicker. The calculation depends on the specific details of the EK. For real estate financing, the EK is often an ownership share of the property’s gross revenues or rental income. Obviously, this makes the calculation easy:
EK = x% of Gross Revenues or Rental Income
For instance, if a 5-year loan has an equity kicker of 20% of rental income, and that income is $1 million per year, then the EK is worth $200,000 per year for the life of the loan.
This example involves preferred equity that carries an equity kicker. Investors may purchase preferred shares from the sponsor instead of, or in addition to, purchasing debt. In terms of liquidation priority, the preferred shares are senior to common shares but subordinate to first-lien senior debt. In this example, the preferred shares provide the investor with 10% of the earnings per common share. If the common EPS is $2, then the preferred shares’ EK is worth 20 cents a share. Of course, the preferred shares retain their other attractive characteristics, including:
- Upside potential relative to debt
- Liquidation priority over common equity holders
- Downside protection due to preferred dividends
- Risk mitigation by purchasing rolling maturities
Should I Sign a Loan with an Equity Kicker?
The terms of the loan’s kicker dictate whether you should agree to the EK or not. Naturally, offering 20% of revenues makes a lot more sense that offering 80%. So, it all comes down to the deal’s details. By agreeing to an equity kicker, you can reduce your interest expense and increase your leverage. Clearly, your best play is working with an experienced commercial loan brokerage that knows the benefits of a properly structured EK.
How Assets America® Can Help
We at Assets America® have decades of experience with all types of loans, starting at $10 million. We can help you structure a loan with an equity kicker that works for all parties concerned. Please call us today for a private consultation.
Frequently Asked Questions
What are recharacterization issues in equity kicker mortgages?
Recharacterization occurs when a court or the IRS determines a transaction is improperly structured. This can occur with an equity kicker mortgage on issues like deferred or contingent kickers. Recharacterization can lead to a mortgagor losing tax benefits and having to pay interest and penalties.
What’s the difference between a kicker and an equity kicker?
Not all real estate kickers are equity kickers. An equity kicker involves an ownership interest in the sponsor or the property’s cash flows. A non-equity kicker can be a set of fees that the borrower must pay when the property changes ownership.
Is an equity kicker related to mezzanine financing?
Yes, mezzanine financing can involve an equity kicker. Alternatively, a borrower may use an equity kicker instead of resorting to mezzanine financing. In either case, the kicker sweetens the deal by contributing equity to investors and lenders.
What is strip equity?
Equity stripping is a strategy of encumbering real estate assets with one or more liens so that little equity remains. This protects the property from inside and outside liabilities. In effect, it makes a property seem worthless to a junior creditor.