"Preferred Equity" = "Second Position Lending" And Should Be Compensated Accordingly

[Scott Trench]

When a syndication or fund wants to buy an apartment building, for, let's say $10M, they have two basic options to finance it: 

- Debt

- Or Equity

Equity is expensive, as investors demand high returns. It takes on the most risk, and it has the most upside. 

Debt is cheaper, and the more you can put on the deal, the more you jack up equity returns. 

Banks right now are not lending up to the same LTVs as a few years ago, and/or DSCR covenants are not allowing assets to be capitalized with as much debt. It's also almost impossible to get any institutional lender to provide mezzanine (second position or more junior financing) on many deals.

Purchasing real estate with 50% equity often does not provide a very compelling financial model that attracts LP capital. Hard to argue that you can drive a 15% IRR on a 100 unit multifamily in a city with lots of supply coming online, rising taxes, and insurance, and using a 50% down payment. At 75% Debt to equity, though? Ok, even a little rent growth over the next 5 years can make this compelling.

So, syndicators and those raising funds to buy commercial assets are turning to "preferred equity" in order to raise the necessary funds to close  a deal, while giving the equity investors more leverage and a shot at higher returns. 

Preferred equity isn't bad. It's commonly used in many deals. 

I'm just posting today, because I think that investors considering "preferred equity" need another spin on this type of investment. 

It's second position debt. It has all the characteristics of second position debt. It earns an interest rate. Returns are often capped (because they are essentially interest). It's junior to the bank debt. While it can sometimes get advantages similar to equity for tax treatment or even participate in depreciation in certain structures, for all intents and purposes, investors need to view it as a loan. Junior to the bank.

Right now, mortgage rates are 7.7% for people with 800 credit scores. You can literally lend to someone in first position at 7.7% on a long-term note, right now. I have purchased hard money notes from certain lenders, where I am in first position, up to 75% LTC, and earn a blended 13%. 

If I were to lend in a second position, I'd need north of 15-18% to justify the risk. And, this is a literal opportunity in many areas. I have been sent several opportunities lately on smaller deals. Investors need this last bit of capital very badly on many deals right now and are willing to pay up.

Despite the high yields, I have chosen NOT to participate in any second position loan products. I just don't like the "no mans land" that I feel it puts me in. I'd rather just be on the equity side, or have a conservative LTV and have the right to foreclose.

So, by all means, explore "preferred equity". There are legitimate use cases, and the high yields can be super attractive. 

I'd just be really wary of any offerings in the 8-12% range. That's the kind of yield you can get in first position here in late 2023. If you are going to lend in a junior position, charge more - likely north of 15%.