– The author discusses their frustration with missing out on market opportunities and trends in real estate investing.
– They highlight the benefits of investing in preferred equity, such as immediate cash flow, payment priority, lower risk exposure, and tax benefits.
– The article explains why now is a unique window of opportunity for investing in preferred equity, including increased demand due to lenders pulling back and shortfalls in common equity.
– The author mentions that coupon rates for preferred equity are currently higher than in the past, creating potential for superior safety and upside.
– They also discuss the increasing demand for preferred equity as rescue capital for projects with upcoming refinance deadlines.
– The article explains that this window of opportunity for preferred equity may be limited due to potential changes in interest rates, increased institutional investment activity, and competition driving down current pay and coupon rates.
– The author encourages diversification and suggests that investing in preferred equity may not be viable for most individual investors due to the effort and complications involved.
– They conclude by offering BiggerPockets readers the option to connect with an investor-friendly agent and highlighting the resources available on the BiggerPockets platform.
“What is your least favorite aspect of real estate investing?”
Thanks for asking. I sold my company to a public firm over 25 years ago, and I’ve been a full-time investor since. There’s so much to love—and so many frustrations.
One thing I hate is missing the top (or bottom) of the market or not catching a trend until it’s too late.
For example, I wrote a BiggerPockets-published book on self-storage. And I am so glad our firm has invested in self-storage for quite a few years. But I wish we would have started much earlier. I feel the same way about mobile home parks.
I authored a recent BiggerPockets article making a case for investing in preferred equity. This article covers another vital question: “Why are we in a limited-opportunity window for top preferred equity deals right now?”
As a reminder, preferred equity sits in the middle of the capital stack. It can provide debt-like repayments independent of the property’s performance, with additional upside to investors. It generally carries less risk than common equity, but it has limited upside.
As mentioned, we are in a unique window of opportunity to invest in preferred equity right now. Preferred equity is in the press. More deals are available than usual, and with this supply-and-demand imbalance comes theoretically better terms and returns for investors.
At a high level, here are some reasons we like preferred equity:
- Immediate cash flow, future upside, and shorter hold time.
- Payment priority ahead of common equity.
- Lower downside risk exposure than common equity.
- Preferred equity still receives depreciation tax benefits.
- Can negotiate control rights in case something goes wrong.
- Can negotiate a MOIC (multiple on invested capital) floor to juice returns if taken out early.
So Why is Preferred Equity a Robust Investment Opportunity Right Now?
You may be wondering why preferred equity is having such a moment in the sun. Here are four reasons why.
Many lenders are pulling back compared to 12 to 18 months ago, drastically increasing demand for preferred equity.
We have all heard stories about lenders refusing to lend on deals. Many that are funded close with lower loan-to-cost ratios and stricter terms. This has created a gap, which won’t necessarily last forever, whereby sponsors scramble to close deals by employing preferred equity.
Shortfalls in common equity create gap-funding opportunities.
This is a double whammy for sponsors already coming up short on debt. With both equity and debt capital in limited supply, preferred equity or mezzanine debt is often the remedy.
Coupon rates/current pay are much higher than in the past.
We’re typically seeing 16% to 18% coupon rates instead of 12% to 14% for $1 million to $5 million check sizes. This capital crunch has hit smaller deals particularly hard. It is not worth most preferred equity providers’ time to evaluate these smaller deals (especially in light of the current deal volume). But these under-the-radar deals can often provide superior safety and upside.
Sponsors with excellent assets are often caught with an unfortunate capital stack and need rescue capital.
Many excellent projects with upcoming refinance deadlines will not get funded as planned. Sometimes, this has nothing to do with the sponsor or project. Injecting preferred equity is often the only way forward. Though my firm isn’t investing in rescue capital, the increasing demand for it is placing additional demand on a limited supply of capital.
But Why is This Such a Limited Window of Opportunity?
Now is clearly the time for preferred equity deals, but here are four reasons the window may close when current market conditions shift.
When interest rates drop, banks will start lending at higher leverage and relaxed terms again.
As the credit cycle ebbs and flows, lenders will predictably change their underwriting standards and terms. High interest rates and tighter terms are creating an excellent opportunity for us right now, but this won’t last forever.
When interest rates drop, sponsors with floating-rate debt won’t need to recapitalize as much as they do now.
The current conditions have wreaked havoc on sponsors with floating-rate debt. Though we won’t typically invest in these deals, their ubiquity has created tremendous demand on a limited pool of preferred equity dollars. When interest rates drop, the pressure and demand will decrease significantly.
Institutional investment activity and common equity investments will increase when market uncertainty recedes.
The issue here is not just the lower availability of debt. It also hinges on constrained equity availability. Part of the issue is in regard to spooked institutional investors cashing in their shares. The issue is not a lack of investible cash, and at some point, the spigots will open again.
More competition potentially coming for $1 million to $5 million check sizes could drive down the current pay and coupon rates that we’re seeing now.
We’re not alone in spotting this opportunity, especially with the premium returns generated from small check sizes. We believe preferred equity competition in this sector will increase soon; hence, our desire to place more preferred equity as soon as possible.
What About Us?
Our firm believes in broad diversification. We are not raising preferred equity for one-off deals, and we have not established a separate fund for preferred equity. Other fund managers are setting up specific preferred equity funds, and we think that’s a great plan, too.
If you’re interested in investing in a theoretically safer place in the capital stack during this time of uncertainty, preferred equity could be a good option. One of our most sophisticated investors, the founder of a multibillion-dollar hedge fund, agrees. His comments to me on the limited window for this opportunity spurred this post.
If you decide to invest in preferred equity, I don’t believe it’s a viable option for most individual investors. I don’t mean to sound self-serving. But after watching our investment director and his team spend countless hundreds of hours over months to get a handful of deals across the finish line, I can tell you there are a lot of effort and complications. It’s not for the faint of heart.
Many investors are investing in assets with lower projected returns and with the highest risk borne by common equity investors. We are pleased to share this alternative with BiggerPockets readers.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
Property Chomp’s Take:
Real estate investing can be both exciting and frustrating. As someone who has been a full-time investor for over 25 years, I have experienced a wide range of emotions when it comes to this industry. One aspect that I particularly dislike is missing out on opportunities. Whether it’s failing to catch a trend early or not timing the market correctly, these missed chances can be quite disappointing.
For example, I wrote a book on self-storage and have been investing in this sector for several years. However, I often find myself wishing that I had started even earlier. The same goes for mobile home parks. It’s frustrating to realize that I could have been benefiting from these investments much sooner.
Recently, I published an article on BiggerPockets discussing the benefits of investing in preferred equity. Preferred equity sits in the middle of the capital stack and offers debt-like repayments along with additional upside for investors. It’s generally considered less risky than common equity but also has limited upside potential.
Currently, we are in a unique window of opportunity to invest in preferred equity. There is a higher supply of deals available, which has resulted in better terms and returns for investors. Here are some reasons why we find preferred equity appealing:
1. Immediate cash flow, future upside, and shorter hold time.
2. Payment priority ahead of common equity.
3. Lower downside risk exposure compared to common equity.
4. Depreciation tax benefits still apply to preferred equity.
5. Control rights can be negotiated in case of any issues.
6. Returns can be juiced if an early exit is taken through negotiation of a MOIC floor (multiple on invested capital).
So why is preferred equity such a robust investment opportunity right now? There are four key reasons:
1. Many lenders have become more cautious, resulting in increased demand for preferred equity.
2. Shortfalls in common equity create opportunities for gap-funding with preferred equity or mezzanine debt.
3. Coupon rates/current pay are higher than in the past, offering attractive returns.
4. Sponsors with excellent assets sometimes find themselves in need of rescue capital due to their capital stack.
While the current market conditions present a great opportunity for preferred equity deals, it’s important to note that this window may not last forever. Here are four reasons why the opportunity may close:
1. When interest rates drop, banks will start lending at higher leverage and relaxed terms again.
2. Sponsors with floating-rate debt won’t need as much recapitalization when interest rates decrease.
3. Institutional investment activity and common equity investments will increase when market uncertainty recedes.
4. Increased competition for smaller check sizes could potentially drive down current pay and coupon rates.
At our firm, we believe in broad diversification and are not raising preferred equity for individual deals. However, we recognize that investing in preferred equity during this uncertain time can be a good option for those seeking a theoretically safer place in the capital stack.
It’s worth noting that investing in preferred equity is not suitable for most individual investors. The process can be complex and time-consuming, requiring significant effort and expertise. However, for those interested in exploring this opportunity, it’s advisable to seek advice from professionals in the field.
Ultimately, preferred equity offers an alternative investment option for those looking to diversify their portfolios and potentially benefit from the current market conditions. As always, it’s important to carefully consider your individual financial situation and consult with experts before making any investment decisions.