By Eli Moghavem and Michael Bastan, Base Equities

As we enter a recession and real estate values risk declining, many real estate investors either switch to debt strategies for a significantly lower yield, less risk and more current cash flow as they weather the downturn, or they sit on the sidelines making no return (or often incur a negative arbitrage) until market conditions improve.

Preferred equity provides investors with the ability to earn an attractive risk-adjusted return with a significant number of inbuilt downside protections that work to lower risk. Currently, a preferred equity investor can get more credit enhancement than in an up-market given the outsized demand for equity.

How can you earn money in a preferred equity position, given the current economic environment? The first mortgage lender will be getting a fixed return, and the sponsor/common equity will usually get no current cash flow and leaves their equity position exposed to market volatility and value correction. Typically, any remaining cash flow will flow to the preferred equity investor, in addition to the prepaid reserves. Preferred equity offers investors a combination of:

1) Current cash flow

2) Accrual and/or profit participation

3) Downside protection.

4) Fund level diversification and professional due diligence (if investing through a fund)

Current Cash Flow

All preferred equity investments are structured with a current pay component. This is treated essentially like an interest rate. This is represented as some percentage due to the preferred equity partner on a monthly basis. For instance, a $3,000,000 investment with an 8% current pay will be paying $20,000/month ($240,000/year).

If there is not enough cash flow at the property to support the current pay, the preferred equity investor will in most cases take a reserve to cover this payment until the cash flow from the property can support the monthly payment. Using the same numbers as above, assuming the year 1 cash flow is not enough to support the current pay, the preferred equity reserve would be $240,000 which would be net funded from the $3,000,000; so essentially $2,760,000 is funded day 1, but the current pay is charged on the full $3,000,000. The additional credit enhancement ensures payment of the current pay, while also used as a mechanism to lower the basis of the investment.

Investments made into preferred equity funds, rather than one-off investments provide added risk mitigation. The current cash flow is typically distributed to investors on a quarterly basis and is a combination of the entire portfolio’s current pay amounts. If one of the properties fails to pay the current pay, and the reserve is not sufficient to pay the current pay, the cash flow received from the other properties will still be distributed to investors, meaning the investors will always be receiving current cash flow.

Accruals and Profit Participation

The benefit of a preferred equity strategy vis a vis a debt strategy is that the investor return is not capped beyond the current cash flow. In a debt strategy, the lender will only receive their interest payment and will receive a fixed return for their investment. In a preferred equity strategy, the returns are often a combination of a fixed current pay, and additional upside structured as an accrual and/or profit participation

Preferred equity investors must be sensitive to exit cap rates and exit strategies to ensure they are not too reliant on backend profits to meet their yield. In an inflationary environment, interest rates and cap rates can affect exit opportunities for real estate, and it is prudent for manager to be less reliant on potential profits in the future in order to pay investors their expected returns.

A more conservative approach for preferred equity investors is to structure an accrual. This means that the preferred equity will earn their current pay, and then accrue to their intended yield. For example, the investor can receive an 8% current pay, but an additional 8% per annum is accrued and paid to the preferred equity investor at the time of redemption, totaling a 16% per annum return on investment. This accrual is paid before the common equity receives any return of principal. Thus, it is possible for the preferred equity investor to receive the accrual and their full entitled return while the common equity incurs a loss at the same time.

Oftentimes the best approach is a blend of both accrual and profit participation. This ensures a reasonable minimum yield after the accrual is paid as well as the opportunity for additional upside if there is future value appreciation.

Downside Protection

Given the current market dynamics, the most compelling feature of preferred equity is its downside protection mechanisms. Preferred equity always gets paid first after the debt and before the common equity. This common equity acts as a cushion that always takes the first loss. The entire common equity ownership must be wiped out completely before the preferred equity investor loses a dollar. More value protection is added when investing in a preferred equity fund, as the fund-based investing will be able to further insulate the investor from losses.

For example, if the preferred equity investor has a maximum equity investment to cost of 85%, 15% of the value of the property can be lost before the preferred equity investor is affected. This assumes no imputed profit as part of the sponsor’s business plan (e.g. a value add renovation). In a fund structure, often times the losses must be more severe for the investor to be materially impacted.

Preferred equity investments are typically structured with control provisions to protect the investor’s investment.

a. Cash flow protection – the preferred equity investor is receiving essentially all cash flow from the property while its investment is outstanding. Typically, all cash flow will go to pay the current pay, then the accrual, then pay down the principal investment, leaving no cash flow for the sponsor to take home. This keeps the sponsor motivated to complete the business plan and incentivizes them to redeem the preferred equity investor as soon as possible.

b. Default provisions – preferred equity investments are typically structured with default provisions. These are usually the bad-boy carve outs and defaults for non-payment of the current pay. Different preferred equity investors may structure in more default provisions, such as requirements to replenish the preferred equity reserves, delivery of financials, net worth and liquidity covenants, material changes in value and other mechanisms to provide additional credit enhancement.

c. Second level of sponsorship – the preferred equity investor can offer additional downside protection by acting as a second level of sponsorship. In cases of mismanagement, or default on the senior loan, the preferred equity investor can step into the sponsor’s shoes to “right the ship.” The preferred equity investor offers an additional set of eyes on the project, reviewing financials and attending site visits to make sure the business plan is staying on track. Investors should always confirm that management has experience as operators in the case management of a property must be taken over and the business plan must be fulfilled. Additionally, preferred equity funds often have the resources and capital needed to support the property financially and with management expertise to complete the business plan and dispose of the asset when the market recovers. Preferred equity investors should not be investing in asset types or markets where they cannot operate the property.

Fund Level Diversification and Professional Due Diligence

By following a diverse allocation strategy, fund managers can ensure that their investments are allocated across many different locations, asset types, sponsors and strategies (e.g. value add or ground up development). This diversification ensures that if one region, asset type or sponsor is adversely affected, it will have limited impact on fund returns as it comprises a small part of the overall portfolio.

In addition, it allows fund managers to pursue one-off deals that might fit outside the conventional box (e.g. below target current cash flow) if there is enough portfolio wide cash flow generated. Oftentimes it is these one-off deals that provide exceptional returns to investors through more upside participation.

A professional fund manager will also do far more due diligence on sponsors than common equity investors are able to. This will typically include:

– Criminal and credit background checks

– Review of past real estate performance

– Sponsor’s personal liquidity verification

– Review of personal financials.

– Property level diligence

– Site visits

– Property tax analyses

– Review of third party reports (appraisal, phase 1, engineering, zoning, etc.)

– Comprehensive review of budgets

– Post-closing site visits and financial reporting review

The diligence and underwriting process further ensures that sponsors have the means and experience to provide additional support to the asset if needed.

Conclusion

Although it may appear counterintuitive to invest in real estate equity when facing a downturn, preferred equity can offer investors downside protections and current yield as well as additional upside while still being in a lower risk position than common equity.

Base Equities is a nationwide fund-based provider of preferred equity, specializing in small-balance commercial real estate transactions with established sponsors, where the preferred equity investment is between $1M-$5M.