Embarking on the journey of real estate investment requires a discerning choice of financial instruments, each carrying its own set of merits and challenges. Among these, preferred equity emerges as a strategic yet often underappreciated avenue for investors. This blog post delves into the essence of preferred equity, shedding light on its principles and uncovering the reasons why investors are drawn to this unique investment approach.
Life and real estate share a commonality—they both unfold in cycles marked by highs and lows, moments of joy and challenges. In the realm of multifamily investments, the past decade witnessed a bonanza for investors, primarily relying on common equity for property acquisitions and developments. However, as the market dynamics shift, presenting challenges such as a drop in transaction volume and a scarcity of lucrative deals, multifamily investors face a pivotal choice on how to adapt.
In this landscape of high interest rates, low transaction volumes, and diminished returns, the search for alternatives becomes imperative. Among the viable options, a noteworthy strategy involves exploring different facets of the capital stack, particularly debt and preferred equity. The appeal of preferred equity arises from its potential to provide a “win-win” solution for both investors and property owners, especially in the face of challenges posed by changing market conditions.
What is Preferred Equity:
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Pref Equity Opportunity:
Back in the day, variable debt was the savvy pick, giving sponsors the freedom to pull off business plans like a pro. But things have changed in today’s world. The once cool interest rates for fixed debt, cruising around 3-4%, have taken a nosedive, landing us in the harsh reality of current loan rates swinging between 7-8%. This big gap in the cost of capital throws a major wrench in the works for business plans that count on refinancing.
In the face of these challenges, sponsors find themselves at a crossroads, considering various alternatives to navigate the complexities. Among the options available—capital injection, investor loans, loan modification, foreclosure, and bankruptcy—preferred equity emerges as a compelling solution.
Preferred equity becomes a lifeline for both investors and property owners when traditional paths are hindered. This strategy involves private capital, in the form of debt funds and preferred equity, providing the necessary bridge capital to salvage distressed assets. The investor, in turn, benefits from immediate cash flow with limited downside.
Balancing Risk & Reward for Pref Equity Investing:
Preferred equity entails a trade-off between security and potential upside. While investors enjoy a stable and risk-adjusted return based on their position in the capital stack, the common equity reaps the benefits if the project exceeds expectations.
This is not to go without discussing the potential risks and rewards when investing in a preferred equity deal:
Risk #1: Investing In Underperforming Properties
Some preferred equity is utilized for acquiring distressed properties, often to revitalize them. However, properties facing operational challenges or a market that doesn’t support projected rental growth pose inherent risks. These issues, ranging from mismanaged assets to market conditions, can sometimes be insurmountable. To mitigate this risk, our strategy is to avoid investing in distressed properties altogether. Given our expertise and risk tolerance, we prefer steering clear of deals reliant on numerous external factors beyond our control.
Risk #2: No Equity from Property Value
While preferred equity contributes to the long-term profitability of the asset, its investors don’t directly benefit from any increase in property value. Our returns are primarily derived from interest payments, mitigating the risk of diluted returns if the property’s value skyrockets. Although this structure limits the potential for extraordinary returns, it ensures stable, fixed-rate returns, providing a win-win scenario for limited partner investors and us.
Risk #3: Your Capital Is Tied Up
Investing in preferred equity means committing to a less liquid form of capital, a common characteristic of most passive real estate investments. Real estate, by nature, tends to tie up capital for 5-7 years. If liquidity within this timeframe is crucial for an investor, real estate may not be the most suitable investment vehicle.
Reward #1: You Get Paid First
Preferred equity’s key risk mitigation lies in its position within the capital stack. By securing payment priority ahead of other investors, the risk of losing money or missing regular monthly cash flow is significantly reduced. This structure mirrors the security provided to banks, ensuring a fixed monthly payment as outlined in the contract.
Reward #2: We Can Take Full Ownership If We Don’t Get Paid Every Month
In the event of missed payments, preferred equity investors retain the right to take full ownership of the property, acting as a powerful deterrent for sponsors to default on payments. This ensures that the interests of preferred equity investors are protected, adding an extra layer of security.
Reward #3: We Know Our Cash Flow Amount For The Full Hold Period
Preferred equity investors benefit from knowing the exact cash flow amount throughout the investment’s hold period. Unlike traditional passive real estate investments, where preferred return accruals may vary, preferred equity provides a steady, monthly cash flow, enhancing predictability and reliability.
Reward#4: We Invest In Strong Performing Assets
To mitigate the risk associated with distressed properties, we exclusively invest in strong, performing assets for preferred equity. This strategic choice ensures existing cash flow, well-maintained properties, and high occupancy numbers, indicating a property’s underlying value and the sponsor’s effective management.
Reward #5: Our Partners Have Strong Track Records
Collaborating with sponsors boasting a proven track record of successful exits in properties with similar characteristics adds another layer of risk mitigation. This criterion ensures that our partners have demonstrated competence in executing business plans within comparable markets, reducing uncertainties associated with less experienced operators.
Reward #6: We Know The Markets And We Know Multifamily
Leveraging our extensive experience, with over 12 strong exits in multifamily assets all over the US we possess in-depth knowledge of the markets where our preferred equity is deployed. This familiarity instills confidence in evaluating and executing business plans, ensuring that the chosen opportunities align with our expertise and investment criteria.
In essence, the comprehensive risk mitigation measures embedded in preferred equity investments underscore their resilience and stability within the broader landscape of real estate opportunities.
Diversification for Investing
In the evolving investment landscape, diversification is key. As market dynamics transform, embracing alternatives like debt or preferred equity becomes a strategic response. Diversification, the practice of spreading investments across various asset classes, provides resilience and adaptability in the face of changing conditions.
Real estate, being susceptible to market fluctuations, benefits from a diversified approach. Including alternatives such as preferred equity in a portfolio offers a unique risk-return profile, distinct from common equity or debt. The immediate cash flow with limited downside characteristics of preferred equity aligns with the goals of diversification, providing investors with a resilient pathway for growth and stability.
In essence, diversification recognizes the uncertainty inherent in predicting the future. By spreading investments across different assets and strategies, investors enhance potential returns and mitigate risks associated with any single investment or market segment. This adaptive and resilient approach positions investors to navigate the complexities of the financial landscape effectively, fostering both growth and stability.
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