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Navigating Real Estate Investments: Understanding the Spectrum of Preferred Equity Options

Updated: Jul 4

I've encountered variations of this sentiment from potential investors numerous times over the past year and a half. Wellings Capital, the company I'm associated with, introduced preferred equity into our income fund in 2023. Recognizing its potential and the limited window of opportunity it presents, we've recently expanded our offerings to include standalone preferred equity investments as well.

 

In the following discussion, I aim to clarify some common misconceptions about the different forms of preferred equity available. My objective is to empower investors with the knowledge needed to make informed decisions regarding their investments.

 

What Preferred Equity Isn't

Some investors believe that their commercial real estate (CRE) investment includes preferred equity because they receive a preferred return before profits are distributed among the syndicators.

 

While a preferred return is indeed advantageous, it's distinct from investing in preferred equity. A preferred return ensures that limited partner (LP) investors holding common equity receive priority in cash flow and appreciation up to a certain threshold before profit sharing with the syndicators.

 

For instance, a syndicator might offer LP investors the initial 8% of operational cash flow before dividing additional cash flow and profits at an 80/20 ratio. If cash flow falls below this 8% threshold, investors typically accrue deferred returns until that level is reached before profit sharing begins.

 

What Preferred Equity Is

Preferred equity occupies a position between senior debt and common equity within the capital structure. It combines elements of both debt and equity, sometimes referred to as "gap financing" because it can fill gaps in the capital stack, especially during turbulent times.

 

Preferred equity often includes regular payment components akin to debt instruments, along with accrued and compounded upside potential akin to equity. Currently, it commands a relatively high cost, often in the mid-teens or higher for syndicators. Despite this expense, preferred equity offers investors unusually robust returns with limited risk, with typical internal rates of return (IRRs) ranging from 16% to 18%.

 

Ironically, the present scenario of elevated interest rates, which is compressing returns on common equity, underscores the need for and context of preferred equity. This situation translates into significantly higher returns for preferred equity investors.

 

Four Varieties of Preferred Equity

As previously mentioned, our team has actively pursued preferred equity investments for well over a year. Through our efforts, we've cultivated a selective network of debt and equity brokers who regularly present us with potential deals. (We decline the majority of these opportunities.) This gives us a comprehensive overview of the prevailing types of deals in this domain.

 

Let's delve into four prevalent types of preferred equity deals:

 

Rescue Capital

This form of preferred equity is likely the most widely recognized in current markets. Rescue preferred equity is deployed to salvage distressed deals, a situation increasingly common, particularly in the multifamily sector.


Many of these distressed deals initially relied on floating-rate debt, which was more affordable than fixed-rate alternatives and often came without defeasance clauses. This debt was popular during the pre-rate-hike era preceding the Federal Reserve's 2022 interest rate escalation. However, the subsequent sharp interest rate increases, coupled with stagnant rents and escalating operational costs, have left numerous operators facing financial distress.

 

To mitigate these challenges, operators are turning to preferred equity to inject capital ahead of common equity holders. This capital infusion typically originates from third-party sources, although some operators may first approach existing investors for support.

 

While rescue capital presents an opportunity, it also carries significant risk. Investors must recognize that deals in distress are inherently precarious, with no guarantee of a favorable outcome. However, preferred equity holders typically possess certain rights, such as forced sale options and management controls, which can offer some protection in dire situations.

 

While we acknowledge the legitimacy of rescue capital, our risk tolerance remains conservative, and we have yet to pursue such deals seriously.

 

(Nota: While current instances of this scenario are rare, rescue preferred equity may present an opportunistic avenue for its providers. By intervening in a struggling deal and negotiating takeover privileges, preferred equity providers may seek to acquire the asset in the event of operator default, potentially securing the deal at a discounted price by nullifying common and general partner equity stakes.)

 

Development Capital

Real estate developers frequently utilize preferred equity to finance portions of ground-up developments. As these projects progress, the resulting increase in asset value often enables developers to refinance debt at favorable terms, thereby retiring expensive preferred equity.


This strategic maneuver benefits developers by reducing their reliance on common equity investors, consequently allowing them to retain a larger share of ownership. Likewise, common equity investors stand to gain from increased proportional ownership stakes in successful ventures.

 

While we appreciate the effectiveness of preferred equity in development projects, the associated risks exceed our comfort level.

 

Acquisition Capital

Increasingly, real estate syndicators are turning to preferred equity to fund the acquisition of existing CRE assets. Similar to development deals, preferred equity may bridge the gap between debt and common equity in these scenarios.

Although the high cost of preferred equity renders it unsuitable for most stabilized assets, it proves advantageous for value-add acquisitions with substantial upside potential. The enhanced appraised value resulting from value-add initiatives enables syndicators to refinance preferred equity, thereby granting GP and common equity investors greater stakes in profitable ventures.

 

We view value-add acquisitions as offering an optimal risk-reward proposition and have actively pursued such opportunities.

 

Recapitalization

While preferred equity typically isn't the preferred method for acquiring stabilized assets, owners may opt to leverage it for recapitalizing existing properties. These funds can be allocated for various purposes, including revenue-generating improvements, asset acquisitions, or profit extraction without senior debt refinancing.

This approach is particularly low-risk since stabilized assets usually generate sufficient cash flow to support preferred equity payments. Consequently, we regard recapitalization as an ideal application of preferred equity and have funded several such ventures.


In previous post: "How to invest in real estate"

 

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