Preferred Equity is One of the Best Ways To Earn Double-Digit Returns in This Economic Climate

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Do you know what Warren Buffett did when the financial world was gripped with fear and uncertainty? And what can you and I learn from it? 

I want to be clear: I’m not saying we’re in a financial free fall. This is not 2008. But recent real estate and financial market news points to a downturn we haven’t seen since that era. A significant amount of carnage is already unfolding, and many commercial real estate deals are heading south. 

This is not a rosy moment in real estate paradise. We’ve all seen some of the worst deals done in the best of times. Now, we’re watching for some of the best deals to surface in some of the worst of times. 

So, what types of deals are available right now? Honestly, they’re not that great—unless you know where to look. 

The types of deals formerly penciling internal rates of return (IRRs) in the mid-to-high teens are now coming in at about 11% to 13% or less. That’s if you can find them. 

And economic uncertainties are causing some to sit this round out. While that’s an option, we hate to see investors sitting on cash or Treasuries and breaking even or losing money to ravaging inflation. 

If Buffett’s actions in this downturn are a repeat of what happened last time, we expect to see him making similar moves to what he did in 2008. 

So what did Buffett do then, anyway? He hedged his portfolio by changing his position in the capital stack. Berkshire Hathaway acquired $5 billion of Goldman Sachs stocks when most wouldn’t touch them with a 39-and-a-half-foot pole.  

But Buffett didn’t take the risk other investors took. Instead, he dramatically lowered his risk by buying preferred equity shares on Sept. 23, 2008.   

And we believe you should do the same thing right now—if you can get access to it. 

Why We Love Preferred Equity 

Preferred equity is a hot topic right now. My investment firm, Wellings Capital, is pursuing preferred equity deals to add to our fund. We believe the current financial situation creates a unique window of opportunity. 

So, what do we like about preferred equity? While there is no lien, preferred equity may provide more upside and tax benefits than senior or mezzanine debt. Preferred equity sits between debt (first lien position) and common equity (which has no lien but most of the upside profit—or potential loss). It has some of the advantages of both equity and debt.

Like debt, preferred ongoing equity payments are established in advance, and all, or a portion of, these are paid before common equity distributions. At the time of sale or refinance, preferred equity holders are typically caught up (if behind) before common equity holders receive distributions. 

Here is a look at where preferred equity falls in the capital stack: 

Buffett invested in preferred equity when times were rocky. Likewise, we believe this is a uniquely strategic time to hedge some of our investments by adding preferred equity to our portfolio.  

We are pursuing preferred equity investment opportunities that provide 8% to 10% cash flow and total returns of 15% to 19%. Not only are these returns higher than most deals are penciling now, as mentioned, but the risk is also theoretically lower, and the payments should be far more reliable. However, clearly, there are no guarantees. 

So What’s the Catch? What Does This Cost Investors? 

The downside for investors is limited upside. The maximum total return is typically predetermined in exchange for higher certainty of payments and returns. And preferred equity is prioritized ahead of common equity. 

Preferred equity, like every other investment, carries a risk-reward tradeoff. No one knows the outcome of any investment. 

• In an underperforming deal, common equity and general partners take the hit. (Hopefully, it is limited to them, but again, there are no guarantees.) 
• In a better-than-projected deal, common shareholders, who bear the highest risk, are entitled to the highest return. 

Preferred equity deals with small check sizes (say, $1 million to $5 million) offer investors higher total returns than many common equity deals right now, with lower expected risk. 

You may be wary of these two-tiered investment structures. We felt the same way. But when the economy shifted, we looked harder at what Buffett did in the crisis of 2008. (He went on to succeed wildly, by the way.) 

We’re not necessarily in a crisis yet, but a downturn for sure. 

You are probably already familiar with preferred return hurdles as part of your syndication or fund investments. To be clear, this is not that. The preferred equity we’re discussing here gives investors a higher priority in the capital stack and may provide strong projected cash flow right out of the gate. 

Preferred Equity and the Current Economy

Rarely a day goes by when we don’t hear stories of big multifamily deals in trouble. Some have already foreclosed, and others are heading toward foreclosure. Some are pausing distributions or calling new capital. Many are looking for a quick exit—some at a loss to equity investors. 

This environment strengthens our conviction about changing our place in the capital stack to invest in handpicked preferred equity opportunities. 

The fact is that common and preferred equity investors can’t know the outcome of any investment with certainty. Any deal could be an underperformer or outperformer. All investors are cheering the sponsor on, but preferred equity investors are hedging their bets—and getting potential upside as well. This makes sense to us in an uncertain economy.

A Preferred Equity Case Study

Earlier this year, we reviewed an opportunity for a preferred equity investment into a flagship commercial-grade single-family rental portfolio. This puts the investor behind senior debt in the capital stack and ahead of the common and GP equity. 

Investors expect to receive 10% “current pay” cash flow out of the gate. This should accrue on a compounded basis of 5% annually, which is structured to be paid out upon a recapitalization or sale. An “equity kicker” was also negotiated in the amount of 2.5% (of the preferred equity investment).  

Opportunities like these can benefit investors by providing current cash flow and the potential for appreciation. We calculate the total annual return on this investment to be ~16%, which is meaningful in light of the safer position in the capital stack and the economic environment. However, this is not guaranteed. 

We are evaluating several other similarly structured preferred equity opportunities right now. 

How Can You Get Involved? 

Some of you could make these preferred equity investments on your own. But it’s hard to see how most investors could do that. 

First, you would need to find an operator with a deal. You’d need to invest about $1 million or much more. In addition, you’ll want to undertake a rigorous due diligence process on both the operator and the deal. Then, you would need to draft or edit a lengthy legal agreement. 

And you may have a hard time finding the best projects. We’ve all seen preferred equity opportunities from well-known multifamily sponsors as of late. These investments typically cap you at 8% to 10% total return, with no chance of upside. Nothing is wrong with them, but you might do better if you can access the deals I’m discussing here. 

We are seeing an ongoing stream of preferred equity deals with returns in the mid-to-high teens. You may be able to get additional upside through points, MOIC floors, equity kickers, promote participation, and conversion rights. You can check out an expanded list of preferred equity terminology here. 

We think this is an opportune time for investors to hedge their portfolios with preferred equity. Dedicating a portion of your portfolio to this different spot in the capital stack should provide more safety amidst uncertainty and pay dividends for years. 

The current economic situation and real estate market will not routinely provide the 40% returns many investors experienced over the past decade. We believe it’s prudent to hedge our portfolio with preferred equity to minimize risk while maintaining solid projected returns. We believe the trade of upside for protection doesn’t have to sacrifice total returns, especially in the $1 million to $5 million range, where there can be less competition. 

*Mr. Moore is the co-founder and partner of The Wellings Real Estate Income Fund, 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 future results. 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.