Why Preferred Equity is a Good Commercial Real Estate Investment

Topic:  • By David Scherer • December 19, 2019 Views

Why Preferred Equity

There is a paradox of plenty in today’s multifamily housing market: too many investors are looking for deals. Competition’s driving up prices, making it harder to earn high yields. Instead of the high IRRs we’ve been used to seeing when we underwrite potential deals, we’re finding expected returns are ranging from 12% to 13%. But ownership, or common equity, comes with risk, which is why we’re turning to preferred equity. It can yield anywhere from 8% to 15% returns but offers a protected position that diminishes risk and regular income that equals or can exceed the expected profits we’re seeing from common equity today.

How?  Preferred equity has many similarities to preferred stocks, which income investors love for their set dividend payments that provide them with income. Though more expensive than common stock, preferred stocks pay out first—a huge advantage in uncertain markets. The same principle applies to preferred equity in private real estate, making it an option that can be a good choice for investors when climbing property prices and increasing construction costs cut into profits.

Unlike preferred stocks, which are clearly defined, preferred equity is a general term that refers to a wide class of investments. Investors at this level have a higher priority than common equity investors.  Their cut of any income distributions and ownership comes first, so looking at the capital stack—the hierarchy that dictates whose financial interests get repaid first in a private equity real estate deal—preferred equity sits below common shareholder equity but above debt. If an asset under-performs, this secondary position lessens investors’ risk. Since preferred shareholders must be repaid before common shareholders, its expected risk and potential reward is lower than common equity.

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Like preferred stocks, preferred equity is usually a non-voting ownership stake, though today it’s become flexible. For instance, “hard” preferred equity is similar to mezzanine debt and offers investors some decision-making powers, while “soft” preferred equity may include some financial upside if a project does well. The exact parameters of preferred equity shares—from its rights to its rate of return—are specified in investment offering documents and should be reviewed before an investment is made. Once all debts are paid, preferred shareholders can claim profits until they meet the targeted amount before common equity holders.

A preferred equity position should not be confused with a preferred return, which is a feature of the waterfall of distributions that pay shareholders ahead of managers. The difference can be confounding. Preferred equity shares call for priority distributions, or payment arrangements similar to loans, in which preferred investors must be repaid whatever the project’s cash flow status.

There’s a risk-reward tradeoff in becoming a silent partner with a preferred equity position, rather than taking a controlling interest in private equity real estate. In a money-losing deal, common shareholders and their management co-investors are first to take a hit. In an overperforming asset, both classes of shareholders expect to get their principal back, but common shareholders who bear more risk should be entitled to a higher premium.

Why Preferred Equity Is Our Choice

In a typical preferred equity deal, lenders contribute 60% of the capital stack, and earn the right to be repaid first. The preferred equity owner holds up to 20% of the financing—and is the next in line for repayment—leaving the remaining capital in common shares. With this capital stack, if a $100 million deal loses $20 million, preferred shareholders receive full repayment of their invested equity. Common shareholders bear the entire loss.

Of course, neither common nor preferred shareholders know for sure whether the property will be an underperformer or an overperformer. Both are rooting for a win, but preferred investors are hedging their bets over the common shareholder. And in today’s financing market, this can be a good strategy.

For instance, at Origin we have a rigorous underwriting process designed to limit risk in choosing and structuring deals. Considering the potential for loss, we have been targeting a 13% to a 15% internal rate of return (IRR) for a controlling common equity position or full ownership. Given market fundamentals today, few properties we underwrite pencil out at that rate of return though, and those that do are worth pursuing as a principal owner. More properties fall just shy of such a profit in our projections—let’s say an IRR of 11% to 13%.

In those cases, we look instead at structuring a preferred equity deal. The lower risk of a preferred position would make the lower return worth considering. As it happens, though, preferred equity investments in our emerging real estate markets can command an IRR of 8% to 15%. If putting up preferred equity can produce nearly the same or even higher returns as we would expect owning and managing the property ourselves—with a more protected position—why wouldn’t we take the deal?

Not Always Silent Partners

While preferred shareholders are not managing partners, their agreements often give them special rights. The Chicago-based law firm Blank Rome says preferred shares usually have a mandatory repayment date. Philadelphia-based law firm White and Williams notes that preferred shareholders may be able to block major decisions of the general partners, or to foreclose or remove the developer. That’s not necessarily a good thing, since it may place a sudden burden on the preferred investor to take over management of a troubled project. However, at Origin, we know how to own and grow real estate assets. This is not our plan when we invest in preferred equity, but it gives us optionality.

Behind the preferred investor’s risk-reward calculation are a range of broader financial goals. Many of our investment partners will gladly give up some potential upside if they can generate steady income with less risk. High-return properties such as opportunistic or value-add projects need time to fill vacancies or renovate units. A predictable passive income stream can complement a more fluid turnaround project.

But the current state of the real estate market makes it less worth holding out for a bigger share of potential profit. Tenants’ budgets are stretched. Neither salaries nor family incomes are growing fast enough to afford big rent increases. Valuations are fairly priced, with few bargains to be found. It’s not a world where a 50% annual profit is a reasonable expectation any longer. If returns are most likely to range between 8% and 20%, a protected 8% or 15% is a good outcome.

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David Scherer

David Scherer formed Origin Investments in 2007, along with co-founder Michael Episcope. He has over 20 years of experience in real estate investing, finance, development and asset management.