Preferred Equity: 3 Key Upsides and Downsides

Episode Transcript:  

 Now, it's no secret that the real estate market has been under a lot of pressure the last couple of years, and in return, a lot of different groups have popped up offering alternative types of investments, deals and positions in deals that some investors are not familiar with. Now while none of this is new it is becoming more popular and I think it's really important for investors to understand both the risk and the rewards of some of these alternative positions and structures.

So today we're gonna talk about the three upsides and downsides to being in a preferred equity position. Hey guys. My name is Jeanette Friedrich. I'm the director of Investor Relations here at Blue Lake Capital, where we specialize in multi-family investments across the United States. Now before I jump into talking about being in a pref equity position, I'm gonna start with the basics, which is the capital stack.

When it comes to a real estate deal, who gets paid first is really important to understand, and that's why you wanna make sure that you understand what the capital stack is in a real estate investment. So generally, the way that the capital stock works is. First and foremost, you're obviously going to pay the debt, rather.

This is through a private loan or a lender or however it's structured. The debt is obviously the first priority. Second to that is typically either a secondary loan or a preferred equity position. And then following that is what's called common equity, where limited partners or LPs sit. And then finally, at the top of that stack are the general partners that are typically the sponsors of the deal.

Now understanding who gets paid first is really important, not only because it reflects obviously the risk that you're taking in the structure of a deal, but also the potential reward. So typically, the returns are lowest on the bottom portion of the capital stack, and highest at the top of the capital stack, which is where the, you know, forever famous old adage of risk versus reward comes into play.

And really it's a personal decision for any investor based upon their risk preferences where they wanna find themself in that stack. So this is one of the reasons why preferred equity is becoming really intriguing and potentially attractive to a lot of investors that are wanting to get into a deal in a preferred equity position.

So today I'm gonna unpack for you the three upsides and downsides of taking on. That role. So first of all, the benefit to being in a preferred equity position is that it's predictable cash flow. So it's a fixed rate annually that an investor in a preferred equity position can anticipate to receive.

Typically, common equity or limited partners have more of a variable rate structure that increases slowly over time. However, in a preferred equity position, the rate is. Fixed year over year, quarter over quarter, which can be really helpful to somebody that has a lot of importance focused on cash flow and wanting to know that that cash flow is stable.

Now, the second upside is there's downside protection. I talked about the capital stack and who gets paid first. Well, the lender will always get paid first for the debt, but then following that is generally the pre equity position. Now knowing that you are a priority of getting paid, even before other investors in the deal can bring some people some comfort and help them feel like it's a lower risk investment.

Now, last but not least, typically it also offers more of an attractive risk adjusted return. So common equity positions will typically take a less annual return in exchange for a bigger upside, whereas pref equity will get a larger fixed return. But they take less of the upside potential down the road.

So typically you'll see perfect equity positions structured at anywhere between seven to 9% as an annual payout. So I started to dip my toe in the water of some of the downsides of being in a prep equity position. So let's dig further into what I just scratched on, which is there is a capped upside potential.

So depending on how the prep equity position is structured, most of the time it's either eight. Fixed rate that someone gets throughout the life of the holding period. Or it may be a fixed rate with, you know, some kind of additional little bump or catch up or payment in kind type of position that they have structured towards the end of the deal.

But for the most part, there's a cap on whatever that number can be. And so if a property doubles in value, while common investors in LP and GP positions will be able to fully materialize and benefit from that upside. Pref equity positions do not. Now, the second downside is that there's limited control and liquidity.

So just like any real estate investment, typically, once you're in the deal, you cannot exit the deal until there is a capital event, meaning that the deal is sold Refied. Or recapitalized in some way. In addition to that, typically a prof equity position is very similar to a limited partner position, and you have no control over the decisions that the general partners are making.

Now, sometimes it can be negotiated early on with the general partners and maybe give you a voting right, or something along those lines. But for the most part, generally prep equity positions do not have any control. Now, the third downside of this is that you have to still really rely on the sponsor and the way that they have structured the deal, the way that they've structured the debt and how they are performing on the investment as a whole.

If things start to go sideways, even if you are in more of it preferred position to be paid. The reality is that if the money's not there, it's just not there. Okay, so these are some of the things that you wanna take into consideration if you are considering trying to maybe get into a preferred equity position.

It's up to you, obviously what you wanna do, but a lot of times what I encourage people to do is think about why are you investing in the first place? If everybody else makes 30% on the deal annually, and you took a lower risk position and only made seven, are you really gonna be happy with that? And you wanna make sure that.

Whatever deal you're getting into is structured in a way that you completely understand. I hope you guys found this helpful, and I'll see you on the next episode.