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.
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.)
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.
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.