“You’re investing in preferred equity? No thanks—I don’t invest in rescue capital!”

I’ve heard this comment from prospective investors in different forms more than a few times in the past 18 months. My company, Wellings Capital, added preferred equity to our income fund in 2023. Seeing the power and limited time horizon for this opportunity, we’ve recently added stand-alone sidecar pref equity investments as well. 

Here, I’ll attempt to clear up some confusion about the types of preferred equity available. My goal is to help investors understand this investment in order to make an informed decision about whether to invest. 

I’ve authored quite a few articles on this topic, which you can check out if preferred equity is new to you: 

What Preferred Equity Is Not

Some investors say, “My CRE investment includes preferred equity. I get a preferred return before profits are split with the syndicator.” 

A preferred return is great. Almost every multifamily and other CRE investment offers one. But that’s not the same as investing in preferred equity. 

A preferred return means that common equity LP investors receive preferential cash flow and appreciation up to a certain level before these proceeds are shared with the syndicator. 

For example, an operator/syndicator may offer LP investors the first 8% of cash flow from operations before splitting additional cash flow and profits 80/20. If cash flow is below the 8% level in this example, investors typically accumulate deferred returns, which are paid up to that level before splits. 

To reiterate: What I’m discussing is not that. 

What Preferred Equity Is

Preferred equity is positioned between senior debt and common equity in the capital stack. It shares some of the features and downsides of both debt and equity and is sometimes referred to as gap financing since it may fill a gap in the capital stack in turbulent (and other) times. 

Preferred equity often has a current payment component (like debt) plus accrued and compounding upside (like equity). It is quite expensive right now, often costing syndicators in the mid-teens or above. This can provide unusually strong returns for investors with limited risk. We are often funding preferred equity with IRRs in the 16% to 18% range right now. 

Ironically, today’s higher interest rates that are compressing common equity returns provide a need and context for more preferred equity, in addition to much higher returns for preferred equity investors.

Four Types of Preferred Equity

As I mentioned, our team has been seeking preferred equity investments for well over a year now. We’ve developed a small but effective network of debt and equity brokers who bring us deals weekly. (We say no to almost every opportunity.) This gives us a broad window into the various types of deals that are happening in this space right now. 

Let’s take a closer look at four common types of deals. 

1. Rescue capital

This is probably the most widely known type of preferred equity being marketed right now. Rescue pref equity is used to rescue a struggling deal. Unfortunately, there are a lot of CRE deals in trouble right now, especially in the multifamily realm. 

Many of today’s struggling deals were originally financed using floating-rate debt. These loans were more affordable than fixed-rate debt and often offered no defeasance (prepayment penalties). This gave syndicators a well-needed edge when acquiring often overpriced deals. 

Floating-rate debt was quite popular during the bubble-like years leading up to the Federal Reserve’s rate hike binge starting in spring 2022. This debt was often acquired with a protective rate cap, which guaranteed that rates couldn’t rise above a certain level. Unfortunately, these caps have a limited time frame and must be renewed at some point. 

The sharp interest rate hikes, coupled with cooling rents and burgeoning operating costs, have caused significant distress for operators who assumed this type of debt. Rate caps, which cost tens of thousands or a few hundred thousand dollars at inception, are priced in the millions for renewals. 

Many operators have paused distributions, and some are facing foreclosure. Their options include investor capital calls or an injection of preferred equity. Some are doing both. 

These syndicators are raising preferred equity to place in front of existing common equity. The source of this rescue capital is typically a third party, though some operators invite current investors to provide this rescue pref equity first.

I believe this can be the riskiest type of preferred equity. The deal is already in trouble. There is no guarantee that floating rates will drop this year or next. Multiple factors could cause these deals to go south, and investors need to be aware of this. 

Though preferred equity resides in a much safer position in the capital stack, a foreclosed deal could still wipe out investors’ principal. Thankfully, preferred equity often has forced sale rights and management controls, giving investors some opportunity to save a struggling deal. 

My firm thinks rescue capital is a legitimate use of preferred equity. But our risk tolerance is quite conservative, and we haven’t seriously considered a deal like this yet.  

(Note: Though I don’t know of any examples of this happening now, rescue preferred equity may provide a sort of predatory opportunity for its funders. By rescuing a struggling deal and negotiating takeover rights, the preferred provider may attempt to acquire the asset in the event of operator default. By wiping out the common and GP equity, the acquiring party may get the deal at a bargain price.)  

2. Development capital

Real estate developers often use preferred equity to provide a portion of the capital in a ground-up development. The development process typically results in a significant asset value increase, which can provide the operator with the high value needed to refinance the debt, paying off expensive preferred equity in the process. 

This strategic move can be quite accretive to the developer, who will have to share a smaller portion of ownership with common equity investors. This should also be accretive to the (resulting smaller number of) common equity investors, who will own a larger proportional share of the deal individually.  

Our firm loves the fact that developers successfully use preferred equity. But like rescue capital, for us, at least, the risk is outside our tolerance level. 

3. Acquisition capital

Real estate syndicators increasingly utilize preferred equity to acquire existing CRE assets. As with development deals, this preferred equity may be used to fill a gap between debt and common equity. 

The high cost of preferred equity makes it untenable for most stabilized “coupon-clipper” deals. It can be ideal, however, for value-add deals that have significant potential upside. The higher appraised value resulting from value-adds should allow the syndicator to refinance out preferred equity, giving GP and common equity investors a higher stake in successful projects. 

Our firm believes that many value-add acquisitions provide an ideal risk-reward ratio for investors. We have done a number of deals in this arena and are eagerly pursuing more. 

4. Recapitalization

I mentioned that preferred equity is generally inappropriate for acquiring stabilized assets. However, owners sometimes use preferred equity to recapitalize existing stabilized assets to provide capital for other uses. These uses could range from making improvements to raise revenue, acquiring other assets, or just extracting profit for the owners without refinancing senior debt.

This can be an especially low-risk use of preferred equity since the asset should have existing cash flow to support preferred equity payments. All things being equal, our firm believes this is an optimal use of preferred equity, and we have funded a number of these investments. 

Is Preferred Equity an Investment Opportunity for You?

Why might you want to consider preferred equity? There are several potential reasons:

1. You’ve invested in common equity but are concerned about returns and safety in this uncertain environment. 

2. You’ve invested in debt, and you recognize that pref equity offers a much higher potential return.

3. You are looking for an equity investment with management control rights, forced sale provisions, and (often) a personal guarantee from the sponsor.  

4. You want higher initial cash flow than most common equity offerings right now. 

5. You are seeking a shorter hold time than many common equity investments. 

6. You’ve considered a diversified fund but opt for the clarity offered by investing in a single asset.

Interested in learning more? Let’s start a conversation here. Or feel free to reach out to me directly.

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Mr. Moore is a partner of Wellings Capital Management, LLC, the investment advisor of the Wellings Real Estate Income Fund (WREIF), which is available to accredited investors. Investors should consider the investment objectives, risks, charges, and expenses before investing. For a Private Placement Memorandum (“PPM”) with this and other information about the Wellings Real Estate Income Fund, please call 800-844-2188 or email [email protected]. Read the PPM carefully before investing. Past performance is no guarantee of futurebresults. The information contained in this communication is for information purposes, 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.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.