UPDATED: Preferred Equity Investing 101

Many investors rely on the fixed income in their investment portfolios to pay for their everyday expenses and lifestyle.  With the recent run-up in interest rates, many investors have moved their idle cash into money market accounts and other fixed income bond portfolios or treasury securities like t-bills, notes, and bonds.  Before the Fed increased the benchmark rates and the corresponding market move of higher interest rates, these fixed income securities offered very low returns and were less interesting for those investors who were looking for slightly higher yields.  The biggest loser due to the run-up interest rates appears to be junk bonds and high yield credit instruments due to their lower credit quality and now uncompetitive rates. 

Many market prognosticators as well as the Fed have signaled that rates are likely to continue to come down over the next year or two.  In a falling interest rate environment, investors like to lock in higher yields on similar risk assets in order to match their current level of income received from their fixed income portfolio in order to maintain a set level of dividends and distributions per month, quarter, or year.  Some investors may be keen on locking in higher interest rates now for a set period of time.  We have seen the institutional investors move on this strategy.  In our affiliate company, Schelin Uldricks & Co. we have seen credit spreads tighten which means that the demand for commercial mortgage-backed securities has increased. In the same way that it would have been smart to sell fixed income ahead of rates going up, it may be smart to buy fixed income ahead of rates going down.

One strategy that is potentially worth considering is preferred equity investing.  Preferred equity is typically a hybrid security that sits between senior secured debt, like a mortgage, and common equity.  Preferred equity is also often called mezzanine debt.  While similar, there are some differences between the two and the most common differentiator is the security that an investor receives in mezzanine debt.  In the modern finance world, it is more common for accredited investors to get access to preferred equity investments.  Preferred equity is ubiquitous across public and private markets.  Investors can gain access to preferred equity investments through their investment platforms like Fidelity and Vanguard or they can access preferred equity investments on the private market as well.  On the major public platforms, preferred equity investments offered are usually preferred equity investments in public companies which can be great investments.  Another option for accredited investors to access preferred equity investments is in private real estate.  Due to the increase in interest rates, real estate sponsors are in need of preferred equity to complete a refinance or complete their business plan.  Often, these investments offer high rates of current income to investors.  At Pierside Capital, we arrange preferred equity investments in real estate that target 13% – 16% current pay.  So, in other words, on a $100,000 investment, we are receiving $13,000 – $16,000 per year in distributions on a 3–5-year deal.  These investments compared to the three-to-five-year treasury bond and comparable public company preferred equity investments can be two to three times the rate of return.  However, it’s important to note that the higher yield also results in higher risk so it’s very important for accredited investors to fully understand the risks before making an investment.  There are certain considerations an accredited investor must make before making an investment.  Here are a few (but not all) things to consider:

1. First Dollar In: The First Dollar In represents the attachment point within the Capital Structure.  The Capital Structure is defined as the mix of capital within a certain deal.  Let’s use this example to understand First Dollar In and the Capital Structure.  Let’s assume that a real estate sponsor purchases a $10,000,000 investment property and utilizes mortgage debt to acquire the property.  Let’s say that they borrow $6,000,000 out of the $10,000,000 to acquire the property and need $4,000,000 of additional capital to complete the purchase.  In this case, let’s assume that the sponsor has $2,000,000 they would like to invest in the form of common equity and are out in the market raising $2,000,000 of preferred equity.  In this example, the first dollar in for the preferred equity is the first dollar after the senior debt, or $6,000,001 or 60.01% LTV.  This is the first dollar in.  The higher the first dollar in, the higher the risk for accredited investors.  It’s important to fully analyze this to understand the level of risk involved.
2. Last Dollar In: Following the same example above, The $2,000,000 of preferred equity that our real estate sponsor is raising has a Last Dollar In at $8,000,000 of the above $10,000,000 total capital structure.  The Last Dollar In represents where the preferred equity investment ends and the common equity investment begins within the Capital Structure.  The Last Dollar In can also be referred to as the Detachment Point.  Just like a train car has a point where it attaches to the locomotive it also has another point at the end of the train car that attaches to other train cars.  The higher the last dollar in, the higher the risk.  Investors need to be compensated appropriately for investing higher in the capital structure.  It’s typical for a preferred equity investment to have a last dollar in at 80% – 85% of the total capital structure.  Anything above 85%, is typically considered common equity by the institutional investor community and the marginal return associated with this increase in risk above 85% can be exponential so it is important to consider the last dollar in versus the level of projected return.
3. Debt Coverage Ratio or Preferred Equity Coverage Ratio:  This is also an important measure to consider when making a preferred equity investment.  A coverage ratio is expressed as a positive or negative number.  The higher the number, the higher the quality of investment.  In our hypothetical example above, let’s say that the preferred equity coverage ratio is 1.25x.  What this means is that after paying all operating expenses at the property, and paying interest on the senior debt there is $1.25 dollars available for every $1.00 owed to the preferred equity investors on their dividend.  In the above example, let’s assume that the preferred equity investment offers a 15% distribution.  On a $2,000,000 total investment, that would equate to $300,000 of total distributions owed to the preferred equity investors per year.  At a 1.25x preferred equity coverage ratio, this would mean that there is $375,000 of cash flow available to service the distribution.  This ratio should give the investors a sense of the feasibility of the project to service the distribution.  After all, the main reason investors choose preferred equity investing is for the high distribution so this should be a major factor to consider before making an investment.
4. Accrued vs. Current Payment: Many times preferred equity investments are offered on an accrued basis which means the distributions may be paid partially or fully accrued until the end of the investment period.  If you are looking for current distributions then an accrual feature may not be the way to go and be a disqualifying factor on an investment opportunity.  Some investors are okay with an accrual feature especially if the unpaid, or accrued portion of the investment is added to the existing balance of the outstanding preferred equity investment.  We often see preferred equity investments that have partial current payment and partial accrual.  Accrual is also known as “paid in kind” or PIK.  What this means is that the investors who forego cash get paid additional preferred equity stock.  In other words, their balance increases on the unpaid portion of the investment.  Let’s assume that a potential investments has a 15% overall distribution but 10% is paid current and 5% is accrued.  On a $100,000 investment, $10,000 would be received per annum in cash and $5,000 would be added to the $100,000 original investment which would give the investor a capital account balance of $105,000 at the end of the period.  For the next year, the 15% distribution would then be calculate off the new capital account balance of $105,000.  This is the power of compounding interest.  Some investors like this approach as their could be potential tax savings if they are receiving the accrued interest in the form of long-term capital gains.  Every situation is different so it’s also critical to consult your CPA or tax professional to understand the tax element.

These factors are just some of the considerations accredited investors should make before they choose to invest in a preferred equity investment.  Every investor should refer to the offering materials for more information and thoroughly review all risk factors before making an investment.  However, for those investors that are looking for additional income and have a higher risk appetite, preferred equity investing for real estate can be a viable investment strategy for accredited investors.