The Market Opportunity
We are always looking for the best risk-adjusted returns in commercial real estate, especially in these uncertain times. One interesting development in the market is the credit market’s dislocation caused by COVID-19. Due to deemed higher risks and uncertainty brought about from the pandemic, many lenders have either been sidelined or have reduced their loan amounts, causing a gap in the multifamily funding capital stack. Additionally, lenders, including Fannie Mae and Freddie Mac are now requiring reserves that are held back from being funded at closing, further exacerbating this gap.
Nevertheless, sponsors are still eager to acquire new deals as well as recapitalize existing properties in their portfolio to take advantage of the extremely low interest rate environment. Preferred equity is a great solution to meet the needs of transactions in this new environment.
What is Preferred Equity?
Preferred equity is an equity investment given priority distributions as well as a priority on the return of capital, only subordinate to the senior lender. Due to this subordination of the common equity, often a fixed rate of return, and default remedies/control rights, preferred equity has many characteristics of a debt investment but has the higher returns and tax benefits of an equity investment in typical multifamily syndication. For these coveted benefits, the investor is often giving up the appreciation potential to the Class B, equity investors.
That said, preferred equity is attractive today for the conservative, income-seeking investor or someone seeking more balance to an otherwise growth-oriented portfolio. We see yields of 10% for preferred equity class A position in the multifamily deals we are involved in today, an attractive rate given the low interest rate environment. But there is potential for even more upside as we discuss below for the savvy investor.
More Attractive that Class A Shares in a Dual Tranche Syndication
The concept of preferred equity is similar to class A shares in a dual-tranche syndication structure which have downside protection and a fixed rate of return. However, true preferred equity is superior to investing in a class A tranche in syndication because not only are the returns higher, a 3rd party preferred equity position provides much better protection through control rights and default remedies.
For example, a preferred equity investment is usually accompanied by the ability to take over management and dilute the common equity in the deal in order to ensure the preferred equity’s objective returns are still met, even in a downside scenario.
Preferred Equity – Deal Example
Let’s take a $10,000,000 deal and assume the sponsor would normally receive a 75% loan-to-value (LTV) loan from a senior lender. Due to the current market environment, the lender is only willing to lend at 70% LTV. The equity requirement then is $3,000,000. However, the sponsor would prefer to raise/invest as little equity as possible and maximize his or her returns and therefore pursues a preferred equity investment.
The preferred equity investor is willing to invest up to 85% LTV, which is an additional $1,500,000 on top of the loan provided by the senior lender. This means the preferred equity position has 15% of equity cushion which is subordinate to it and in a first-loss position. If the property lost 10% of its value, the preferred equity investment would still be fully protected and still have some equity cushion remaining.
In exchange for providing the $1,500,000, the preferred equity investor will receive 8% cash flow, paid monthly as well as accrue an additional 6% to be paid upon a refinance or sale. In total, the preferred equity position is targeting to receive a 14% annualized return with great downside protection. Meanwhile, the remaining/common equity receives all the upside after paying the preferred equity its fixed rate of return.
Wrapping up the Benefits
- Potential for higher fixed-income yield which is only amplified in a low yield interest rate environment. Average annual returns in the 12 – 14% range are achievable over the life of the deal due to this market funding gap/dislocation.
- Structured to provide more protection than a traditional Class A position in dual-tranche syndication.
- Continued flow through tax benefits generating a higher after-tax yield than a typical non-real estate fixed income investment such as bonds.
In today’s market of high prices and great uncertainty, a preferred equity strategy like this is highly attractive to savvy investors who are willing to trade potential upside for downside protection and a greater certainty of achieving stated returns, all while receiving great tax benefits just like a traditional equity investment.
Thanks to Rob Beardsley, of Loan Star Capital, who shared key knowledge and insight into this emerging opportunity.