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How Investors Are Buying Into Preferred Equity To Lower Risk and Raise Returns

by DIGITAL TIMES
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Did you catch the “Woodstock for Capitalists” event this year? I’m talking about the Berkshire Hathaway annual meeting in Omaha. I tuned in for the whole event. With Warren Buffett aged 93 and Charlie Munger approaching 100, any year could be the last year. 

What Munger said about commercial real estate was troubling—but not surprising. 

Munger had previously warned of a brewing storm in the U.S. commercial property market, with American banks full of bad loans as property prices fall. At that meeting, he reiterated his fear, and Buffett reinforced it. 

For years, during real estate’s rising tide, investors clambered for higher and higher returns. They asked, “How much can I make?”  

But the trend always reverses in time. Now investors are asking, “How much could I lose?”

It’s times like this when investors stop discussing returns and revert to discussing risk-adjusted returns.  

Calling All Recovering Speculators

I’m a recovered speculator. A few decades ago, I focused solely on returns and ignored the risks. Now, my firm is obsessed with risk-adjusted returns, which is honestly an altogether different metric. 

While risk-adjusted returns have always been the focus for great investors, there are certain seasons when unusual opportunities surface—deals that don’t present themselves when cash and profits are flowing like green Chicago rivers on St. Patrick’s Day. 

We are in one of those rare moments right now. 

Preferred equity provides numerous benefits, including greater safety from a higher position in the capital stack, immediate cash flow, management rights in case of delinquency, and a common equity cushion behind investors in first loss position as a shield against decreasing asset values. 

To be clear, this is not the “preferred return” investors receive as part of their payout structure from syndicators. That’s great, but that’s not what I’m talking about. 

These opportunities are quite different from the typical preferred equity offers you might have seen from multifamily and other sponsors as part of their offerings. Many of those offer investors a debt-like cash flow stream (for example, 8% to 10%) with little or no upside. 

Investors accept lower potential returns for cash flow and a safer position in the capital stack. We think these are great and that this is a good time to look at those options. But I’m talking about something different. 

Details of the Deals

I made a strong case for preferred equity in an earlier article. In another, I explained my reasoning for why this is a limited window for preferred equity deals. Some have asked for more details on some of the deals we’ve been evaluating. 

I don’t have room to explain them all here, but I’ll tell you about an opportunity we recently evaluated where risk and upside potential are seemingly misaligned—in favor of investors. 

This deal still helped an operator successfully execute an acquisition. 

We are evaluating quite a few preferred equity opportunities with characteristics like this one. Here are some details:

  • Value-add multifamily acquisition, with an experienced sponsor next door to one of their current successful projects. 
  • 25% common equity in first-loss position as a shield behind preferred equity investors.
  • Current pay cash flow of 9% reserved in advance for one year, plus accrued upside of 8% compounded. 
  • MOIC (multiple on invested capital) floor of 1.30x, which provides a 30% minimum total return, with a projected exit in 18 months (up to a 20% annual return if this plays out).   
  • Cash flow sweep and management control rights (including the right to force a sale) to protect investors in case of trouble.  

If you invest in a deal like this, you wouldn’t sign a boilerplate agreement like any of us would do as individual investors. You would want to hire an experienced attorney to craft documents with provisions to protect you and to provide rights that no individual investor would receive (if they could get access).  

The opportunity discussed here is one of many. The total return of 17% (with the potential to receive a higher return if the MOIC floor is triggered in 18 months) is more attractive than many common equity opportunities. 

But the risk is theoretically much lower due to capital stack position, priority of distributions from cash flow (including cash flow seep), current pay reserve, and manager removal rights. 

This investment aligns with many BP investors’ first priority of capital preservation, a second priority of predictable income, and a third priority of equity appreciation. And this one passes through tax benefits from depreciation to boot.  

To be clear, I’m not suggesting investors abandon individual LP investments. We believe in broad diversification, and preferred equity can be part of a great portfolio. 

Recently, I mentioned one of our most sophisticated investors who helped me clarify what a rare and short window of opportunity is available to make investments like these. 

I forgot to mention that he chided me a bit when I was explaining our rationale for investing in preferred equity. But his gentle rebuke was not about investing in preferred equity. He chided me for not investing more in pref equity—especially in this rare and narrow window of time. 

He sees the opportunity. We see the opportunity. And we hope many of you do, too.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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