A Deep Dive Into the Nitty-Gritty Details of Preferred Equity

Key Takeaways:

– The article discusses preferred equity in commercial real estate investments.
– The author provides definitions and explanations of key terms related to preferred equity.
– The article uses a real-life example of a preferred equity investment in a value-add multifamily project.
– Terms such as current pay rate, accrual, personal guarantee, forced sale provision, cash flow sweep, capital improvement reserves, and MOIC floor are explained and applied to the example investment.
– The author emphasizes that preferred equity investments offer lower risk, robust cash flow, and strong total annual returns.
– The article invites readers to learn more about preferred equity and ask questions.

BiggerPockets:

Have you been following our discussions on preferred equity? This has produced some questions on deal structure, terminology, and a desire to see some examples. I’ve discussed the case for preferred equity and why there’s a limited time window here. In addition, I overviewed a recent preferred equity deal in my last article

I’ve covered a lot, but I haven’t provided all the basic terminology investors need to comprehend all these deals. 

BiggerPockets has long been an educational site. As such, we may sometimes get nerdy on details that are of little to no interest to the general real estate investor. This is one of those occasions. 

So, we’re going to take some time in this post to break down the definitions for commercial real estate preferred equity investments. But I’m not just going to bore you with definitions. I’m going to explain the term and then tell you how it worked in a real-life preferred equity investment. 

The Terms and the Investment

This opportunity was a $3.5 million preferred equity investment in the acquisition of a value-add multifamily project with an experienced sponsor in the Virginia Beach area. I’ll state our definition and then, in italics, explain how that term would work in this investment. 

Current pay rate

The portion of the coupon rate that is paid from operations. 

Current pay rate of 9%. This current pay is actually reserved in advance for one year, and the reserved capital could be invested in Treasuries, which are currently paying about 5%. This could enhance potential returns for this investment.   

Accrual

The accrued portion of the coupon rate that is paid at a capital event. 

Annual accrual of 8% compounded. (The current pay plus accrual totals a 17% coupon rate.) 

Personal guarantee

A contractual guarantee by the sponsor or key principal to cover the preferred equity in the event of a default. This is similar to a full-recourse personal guarantee on a loan. 

A personal guarantee would be signed by three key sponsors for this investment. 

Forced sale provision

The preferred equity partner’s right to affect the marketing and sale of the asset(s) if any default provisions are triggered. 

The forced sale provision in this investment would allow the investor to force the sale of the asset if certain provisions (such as reserves, debt service coverage ratios, etc.) aren’t met. The preferred equity investor could force a sale that could theoretically harm common equity to protect their position. 

Cash flow sweep

The preferred equity partner’s right to all cash flow from operations until the cash flow covers current pay entirely, until a predetermined global DSCR is achieved, or until the preferred equity partner is paid off. 

The sponsor agreed to this backup reserve account, which would make cash flow from operations inaccessible to the sponsor until certain hurdles are surpassed. 

Capital improvement reserves

Funds earmarked for capital improvements that are held back by the preferred equity partner and released in draws as progress is made. Sometimes, the draw approval will require results from former improvements to be achieved in regard to rent growth or expense reduction. 

The reserve account in this investment holds the sponsor accountable for executing their plan. But it could also compound returns since it could be invested in Treasuries that may contribute about 5% to preferred investors.  

MOIC floor

AKA minimum multiple. A minimum multiple on invested capital that is triggered if the preferred equity is paid off before that multiple is achieved through the coupon rate. This is similar to a prepayment penalty on a loan. 

The MOIC floor on this investment is 1.30x, which equates to a total minimum profit of 30%. If the sponsor pays off the preferred equity in 18 months as planned, this should result in a 20% annualized return (rather than the coupon rate of 17%). 

If you’d like more preferred equity definitions, you can visit the preferred equity page on my website.

The Bottom Line

At this strange point in the economic cycle, it’s gratifying for many investors to access investments like this. These investments are generally hard to access by individual investors and provide theoretically lower risk, robust cash flow, and strong total annual returns. 

We’d love to hear your feedback and answer your questions on preferred equity and anything else.

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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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Property Chomp’s Take:

Hey there! Have you been keeping up with our discussions on preferred equity? We’ve been diving into deal structures, terminology, and even provided an example of a preferred equity deal in my previous article. But I realized that we haven’t covered all the basic terminology that investors need to fully understand these types of investments. So, in this post, we’re going to break it all down for you.

Let’s start with an example to make things more interesting. We recently had a $3.5 million preferred equity investment opportunity in a value-add multifamily project in the Virginia Beach area. The project was led by an experienced sponsor. Now, let’s go through some key terms and see how they apply to this investment.

First up, we have the current pay rate. This is the portion of the coupon rate that is paid from operations. In this case, the current pay rate is 9%. However, this pay is actually reserved in advance for one year and can be invested in Treasuries, which currently have a 5% return. This can potentially enhance the overall returns for this investment.

Next, we have accrual. This refers to the accrued portion of the coupon rate that is paid at a capital event. In this investment, there is an annual accrual of 8% compounded. When you add this to the current pay rate, the total coupon rate comes out to be 17%.

Moving on, we have the personal guarantee. This is a contractual guarantee by the sponsor or key principal to cover the preferred equity in the event of a default. It’s similar to a full-recourse personal guarantee on a loan. For this investment, three key sponsors have signed a personal guarantee.

Now, let’s talk about the forced sale provision. This gives the preferred equity partner the right to affect the marketing and sale of the asset(s) if any default provisions are triggered. In this case, the forced sale provision allows the investor to force the sale of the asset if certain provisions, such as reserves or debt service coverage ratios, are not met. The preferred equity investor can take this step to protect their position, even if it may harm common equity.

Moving on, we have the cash flow sweep. This gives the preferred equity partner the right to all cash flow from operations until certain conditions are met, such as covering the current pay entirely or achieving a predetermined global debt service coverage ratio. In this investment, the sponsor has agreed to a backup reserve account, which means that cash flow from operations is inaccessible until certain hurdles are surpassed.

Next up, we have capital improvement reserves. These are funds earmarked for capital improvements that are held back by the preferred equity partner. The reserves are released in draws as progress is made. In some cases, the draw approval may require results from previous improvements, such as rent growth or expense reduction. In this investment, the reserve account holds the sponsor accountable for executing their plan. It can also contribute to returns since it can be invested in Treasuries, which have a 5% return.

Lastly, we have the MOIC floor, also known as the minimum multiple. This is a minimum multiple on the invested capital that is triggered if the preferred equity is paid off before that multiple is achieved through the coupon rate. It’s similar to a prepayment penalty on a loan. In this investment, the MOIC floor is set at 1.30x, which means that a minimum profit of 30% must be achieved. If the sponsor pays off the preferred equity in 18 months as planned, it should result in a 20% annualized return, higher than the coupon rate of 17%.

If you want to learn more preferred equity definitions, feel free to visit the preferred equity page on my website.

To sum it all up, preferred equity investments like this can be a great opportunity for investors, especially in the current economic cycle. They offer lower risk, robust cash flow, and strong total annual returns. If you have any questions or want to share your thoughts on preferred equity, we’d love to hear from you!

And remember, the opinions expressed in this article are those of the author and may not necessarily reflect the opinions of BiggerPockets. Happy investing!

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