Why is Preferred Equity So Compelling Right Now? And Why It Will Be Gone Fast

“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.