WHAT IS PREFERRED EQUITY?
John F. Kennedy once said, “Change is the law of life, and those who look only to the past and present are certain to miss the future.” At Presario, we always try to keep our eyes on the horizon to keep your investment safe and grow it as efficiently as possible.
Over the past two years, it has become increasingly difficult to produce the returns (or yield) that were enjoyed immediately after the 2008 Great Recession. As yields have declined, risk has inversely increased. We are now at a point in the real estate cycle where alternate strategies and experience become useful.
One of those strategies is the use of Preferred Equity (PE) instead of Common Equity. Preferred Equity is not new and is a favorite of many institutional investors. Presario has already used this model on two of our projects and they are performing well. Exeter Place & Vista at Rayzor Ranch
DIFFERENCE BETWEEN PREFERRED AND COMMON EQUITY
The differences between the two are relatively simple. Common Equity invests in the project itself and is based on the success of the Sponsor, as well as market conditions and the economy. The Sponsor and investor participate in all of the upside, including appreciation, cash flow, and depreciation, but are also subject to the unlimited downside.
A Preferred Equity investment provides capital to the project that the Sponsor is not able to obtain through conventional debt channels. This capital provides increased leverage for the Sponsor, thus creating the potential for greater returns if the project is successful.
The difference here is that the Preferred Equity holds a priority position when it comes to distributions. The PE return is contracted and backed by the Sponsor and the asset from the beginning of the project. The Preferred Equity investor is junior only to the Senior Debt but sits above all others in the capital stack. Thus, the first money paid is to the PE investor after the debt service is met. This money is paid in full until the contracted return on the investment is achieved. That provides an advantageous level of security to the PE investor.
ADVANTAGES OF PREFERRED EQUITY
The advantage to the PE investor is that it gets paid first. The advantage to the Sponsor is that, once the PE investment is paid back, the PE investor exits the project leaving the Sponsor and Common Equity investors with a larger percentage of the investment. If everything goes as planned, everybody wins.
If things do not go as planned, the PE investor has remedies. PE money is first in line after the Senior Debt and has specific legal rights ahead of the Common Equity.
For example, if a project is worth $40 million and has $30 million of Senior Debt, $8 million of Common Equity and $2 million of Preferred Equity, it could lose $8 million of value (20%) and the Preferred Equity would be paid in full, while the Common Equity would be eliminated.
Why we like Preferred Equity Investments
- Payment Priority over Common Equity
- More Upside Returns than Senior Debt
- Excellent Downside Protection
- Stable, Predictable Yields
- Shorter-term than Common Equity
- Less Risk and Volatility than Common Equity in Uncertain Times
What to know with Preferred Equity Investments
- Upside Participation Limited
- Extreme Cases might require Operator take over on Project
STABLE, RISK-ADJUSTED RETURNS TO DIVERSIFY PORTFOLIO
Preferred Equity provides stable risk-adjusted returns in a time of market instability. The trade-off is no participation in the upside. However, in the current market, PE can provide the same or even higher returns than Common Equity, without the risk profile. We believe adjusting your risk profile during uncertain times is a good business practice. A predictable, stable return with limited upside may trump the potential of holding out for bigger profits.
Preferred Equity offers investors a more secure equity position than Common Equity and provides an opportunity for portfolio diversification. The trade-off is the limited upside potential. Preferred Equity real estate investments are an attractive vehicle to produce yield during periods in the market cycle when a correction feels likely. Presario has seen these cycles before and we believe it is better to be in front of the wave, rather than behind it.
As we move through these trying times, we want to assure you that Presario is always looking for the most secure and profitable place to invest your equity. We have seen this inflection point coming for some time but could not know when it would happen. We were prepared and have tested this Preferred Equity platform already. For the past 18 months, we have been working on a product that will fit well into the future real estate environment.