Why We Are Bullish On Real Estate Preferred Equity
“Where are all the great deals right now?”
As I write this in February 2024, I continue hearing this question in various forms from investors and online.
Many of us were investing in real estate through 2008.
“Half-off” real estate deals were plentiful then. However, we’re not yet seeing significant discounts.
Maybe we will later this year or next year, but I’m not holding my breath.
A vast sum of dry powder is on the sidelines, waiting to invest in discounted commercial real estate deals. If the buyers have this much money, will there really be widespread discounted deals?
We believe that you don’t have to find or wait for heavily discounted properties to invest successfully in the current environment.
Preferred Equity In 2024
We believe one of the best real estate investment opportunities over the next 6-12 months or so (from a risk-adjusted return perspective) is preferred equity for private commercial real estate.
Why? I’ll share two significant reasons and elaborate below.
Preferred equity is less risky compared to common equity.
Due to current market conditions, preferred equity offers investors unusually high risk-adjusted returns.
In the market right now, we’re seeing 7-10% annual current pay (annual cash flow) and 14-17% coupon rates (average annual return).
Before elaborating further, let’s discuss the definition of preferred equity.
Preferred equity sits between debt and equity in a traditional capital stack. It features some of the best aspects and downsides of both debt and equity. See a graphic example below.
Some note that preferred equity occupies the same position as mezzanine debt in the capital stack, and that is true. Some investors think their “preferred return” in a typical syndication means they are invested in preferred equity. This is not the case at all – the word preferred has a different meaning in this context.
We believe the safety of mezzanine debt is slightly higher, while the returns offered by preferred equity are generally higher (especially now). For additional terms and definitions related to preferred equity, see our blog post from last year here.
Some features of preferred equity:
Immediate cash flow, future potential upside, and shorter hold time (typically 3-5 years) compared to some common equity investments
No lien, but like debt, it receives preferential payment and return of principal priority compared to common equity
Can get a personal guarantee from sponsors (who typically have significant net worth)
Can receive depreciation tax benefits
Can negotiate control rights and/or forced sale rights in case something goes wrong
Upside is capped, which is accretive to the common equity in the deal
Common equity in first-loss position may shield against value drops
Mandated reserves and ability to earn interest on reserves via sweep account
MOIC (multiple on invested capital) floor can potentially increase returns in case of early exit
These features and protections mentioned above will vary depending on the deal.
For example, some believe that depreciation is not available for preferred equity. Though this is not guaranteed for every deal in the future, we successfully negotiated depreciation for our investors in every preferred equity investment that we have done (typically pari-passu with common equity).
If you’re curious why sponsors want “expensive” preferred equity at a 14-17% coupon, we answered this question in a separate blog post here. Just scroll down to the section entitled “A Question About Preferred Equity From a Prospective Investor”.
What Are the Uses of Preferred Equity Right Now?
Some believe that preferred equity right now is only being used for rescue capital. While rescue capital is a use of preferred equity, there are other uses. Let’s look at the four uses we see regularly in the market right now.
Acquisition – we see value-add opportunities with a proven path to higher income and value as an ideal candidate for preferred equity.
Recapitalization of existing property – this may include filling a gap behind new senior debt or providing liquidity without acquiring new senior debt.
Development – developers often have high projected profits and can afford pref equity’s hefty price tag. Investors should know this will undoubtedly carry a higher risk than the two categories above.
Rescue capital –Syndicators with troubled deals often seek preferred equity to buy a new rate cap, replenish debt service or other reserve requirements, or make capital improvements to boost NOI with the hope of refinancing later.
Through the Wellings Real Estate Income Fund (the "Fund"), Wellings Capital has invested preferred equity for acquisitions and recapitalizations, which aligns with our risk-averse tendencies.
Wellings has not done development, and we do not plan to. Additionally, Wellings has not done any rescue capital deals and would only do so in special circumstances that meet our due diligence criteria.
An Example from a December 2023 Investment in Our Wellings Real Estate Income Fund
In December, the Fund closed on a ~$4 million preferred equity investment in an Atlanta MSA multifamily property.
The property our Fund invested in
This workforce housing property was acquired by an operator with years of experience owning and operating multifamily assets in the submarket near the property.
For this acquisition, our operating partner got a new Fannie Mae loan fixed at 6.61% for five years with three years of interest-only payments.
Overview of terms and projected returns for this preferred equity investment:
9% current pay cash flow*
8% upside accruing and compounding monthly (17% coupon)*
The Fund held back $355,122 in current pay reserves plus $2.55 million in holdbacks for capital improvements
Total IRR projections of 19.4% (including income from the Fidelity sweep account). IRR could increase if MOIC floor is triggered by early payoff*
MOIC is projected to be 1.62x in 36 months*
Approximately 70% LTC last dollar detachment point, meaning there is about 30% common equity in first-loss position before the Fund’s preferred equity position
Here are other important considerations for this preferred equity investment:
Current pay is senior to all other equity on distributions of cash flow after debt service
Full return of capital to the Fund's preferred equity before common equity gets distributions from capital events
Full payment of all compounded accruals to the Fund's preferred equity before common equity gets distributions from capital events, including return of capital
Pari passu depreciation with common equity
All common equity would be forfeited before the preferred equity capital and full return is affected
Holdback of capital improvements to be released in draws as work is completed, per the Fund's unilateral approval plus annual budget approval rights
Forced-sale rights to protect the Fund's capital and returns prior to a potential senior loan foreclosure
While the Fund doesn't have full control rights due to Fannie Mae requirements, the budget approval process gives the Fund the "power of the purse"
The operator plans to secure a supplemental loan in approximately three years, which would result in an exit for the Fund's investment. We negotiated a MOIC floor of 1.50x, meaning that if the Fund is taken out earlier than planned (there is no guarantee there will be an early exit), the Fund could receive an even higher annual return. Note that this preferred equity investment is not accessible outside of the Fund.
The projected 19.40% IRR (with the potential of achieving a higher return if the MOIC Floor is triggered) is as attractive or more attractive than many common equity opportunities we have reviewed recently. However, the risk is much lower with the capital stack position, priority of distributions from cash flow (including cash flow sweep), current pay reserve, capital improvement holdback and draw approvals, and forced-sale rights.
Please recognize that the projected IRR for this investment may not be achieved. The projected IRR above is for this investment only, not the Fund.
For more information on the Fund’s projected returns, please email us at invest@wellingscapital.com or use this link to set up a call.
* DISCLAIMER: Past performance is no guarantee of future results. There is no guarantee that any projected results will be achieved. Investors should consider the investment objectives, risks, charges, and expenses of the Wellings Real Estate Income Fund (the "Fund") before investing. For a Private Placement Memorandum (“PPM”) with this and other information about the Fund, please call 800-844-2188 or email invest@wellingscapital.com. Please read the PPM carefully before investing.
The information contained in this article is for information purposes only, does not constitute a recommendation, and should not be regarded as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be in violation of any local laws. All investing involves the risk of loss, including a loss of principal. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisers before investing. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete and thus should not be relied upon as such.