Preferred Equity passive investing - multi-family. Is the Juice worth the Squeeze?

Question

Seeing many new opportunities for us passive investor types, including "Preferred Equity funds". For example only, Wellings Capital raising 5 mil for a one property specific syndication of a purchase and value add to a Multi-family property in Baltimore Maryland built in 1948, section 8 housing. The Sponsor needing 5 mil for project in addition to the common equity raise, will be in a preferred equity position ahead of common equity and of course behind the Lender with apparently no legal recourse to foreclose property. This Tranche will get an 8% preferred return and then up to projected 14% total annual return, the 6% above the first 8 will be split 75/25. I ran the numbers for any investment below 250k and for the 3 year hold period after 1% annual management fee and 1.25% startup fee, and the profit split, comes to 10% compounded return or an 11.2% avg annual return on a 1.33 EQM on 3 years. In others experience is this return worth the risk given Multi-family environment ie supply, interest rates, project specific risks, illiquidity risk, and more specifically the Preferred Equity subordinated tranche risk (this sounds like just a Mezzanine loan without recourse). This is not a rescue type situation nor a new development type situation but rather an existing high occupancy project, but why can't a sponsor raise enough common equity?

{This is a general question on preferred equity investing not Wellings specifically, they seem like well run/professional/experienced group.}

Paul Moore · Answer

Hey @Paul Azad and others. I just saw this, and though I am 5 months late to the party, I want to answer some of these questions for the record.

As a disclaimer, I want to mention that every investment has risk and there is no guarantee of any return on this investment or any other investment.  And note that this investment is closed to new investors, so it is unavailable now (it filled up in 3 business days).  Our investments are available for accredited investors only.

The targeted returns are net of all fees. So, the ongoing net cash yield of 6.5% to 8% is net to investors.  And the total projected return of 14% to 15% is net to investors (rather than 11.2% - you would be correct if those fees had to come out). @Evan Polaski was correct about this being net.

Note that we also held back $3.9 million of the $5.5 million raised in this sidecar, so there was only about $1.6 million “at risk” originally.  And this means that we are earning interest at ~ 4.5% to 5% or so on the balance we are holding back. That all goes into the return (as a “bonus”).

There is about 20% in common equity in first-loss position behind us.  Meaning the asset could lose 20% or so of its value before impacting our position.

The asset was purchased for $20.2 million with assumed fixed Fannie Mae debt at 4.91% (term through 3/2034).

There was a good bit of understandable discussion about the terms…how we mitigate risk for ourselves and investors. Here are a few bullets on this topic:

• 1. Full return of capital & accrued upside to pref equity before common equity gets distributions from capital events, including return of capital
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• 2. Wellings preferred equity receives the same depreciation allocation as common equity, and sidecar investors receive a K-1 annually
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• 3. Forced sale rights in the event of pending lender foreclosure
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• 4. Holdback of capital improvement budget to be released in draws as work is completed per Wellings’ unilateral approval plus annual budget approval rights
• 5. While no technical control rights due to FNMA requirements, the budget approval process gives Wellings “the power of the purse”

@Evan Polaski was correct again in saying that we do not provide rescue capital and we definitely don’t raise pref equity to bail out our own troubled deals.  And that we had to get a higher return to offer this net return to investors. And that we have to underwrite an enormous number of deals to make a few pencil. Last year we looked at 515 operators and deals and only invested in 11.  And we already knew 7 of those operators!

So why on earth would someone pay us about 17% total for preferred equity. There are a lot of potential reasons.

• 1. The sponsor can take us out after a few years. This will give the sponsor and/or the LP investors significant additional ownership.  If they are long-term holders, this can be significantly accretive to their wealth.
• 
• 
• 2. Preferred equity allows the sponsor to assume a low-interest loan that they can keep in place for about a decade. The math makes sense.
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• 3. This experienced sponsor “knows” they can invest our capital to raise rents and revenue at a level higher than the cost of capital. This asset has clear intrinsic value/value-add potential that is hard to acquire in multifamily these days.

Last, @Ned Carey, I agree with you. I recommend everyone get Brian’s book. Brian
is a friend, and he lives out what he wrote!

And if you’re planning to invest in CRE passively, check out www.passivepockets.com – it just went live today!

Ned Carey · Answer

@Paul Azad weather the juice is worth the squeeze depends on the specific deal and details. Most importantly what do you know about the sponsor and what is their track record. How does their track record compare to their past forecasts.

I highly suggest the book by @Brian Burke On passive investing 'The Hands Off investor"

Evan Polaski · Answer

@Paul Azad, regarding your example, I would confirm if the projected 14% return is net of all fees and carry or gross.  My sponsors will market their net fees, but I have not participated in any pref equity positions, so not sure what is "market".

Second, let's assume the 14% projection is net of all fees and carry, that means the underlying sponsor actually needs to create a much higher than 14% return to Wellings to ultimately net you the 14%.  Without crunching real numbers, my napkin math is probably close to 20% avg annual return.  This is some expensive money for the underlying operator.

So, if the juice worth the squeeze: to me, I generally don't even bother looking at pref equity investments as an LP.  Why?  While this is likely not true for Wellings, I see many, many formerly equity syndicators that seem to have deals going sideways from 2021/2022, now all of a sudden being "private credit" syndicators (I have noticed a lot of these pref equity funds/investments are calling themselves private credit, which clearly has a broader meaning).  This gives me major pause.  Being the creditor is, in many ways, just as hard, if not harder, than being the equity syndicator. As creditor/pref equity, you need to underwrite the asset, just like an equity syndicator.  Then you also need to underwrite the syndicator and their operational capabilities.  You are stepping in to catch some form of falling knife on a deal and team that dropped the knife to begin with.

I was recently discussing pref equity with a friend that is currently in market with a pref equity fund.  He noted their fund had not placed any capital yet.  They looked at dozens (maybe he said over 100) deals and only three penciled.  Of those three, they started moving on one.  They ultimately walked away because this fund requires "a seat at the table" with key decision authority on when the asset can be sold or refi'd.  The operator was not willing to give up that kind of control.  Which brings me to my second issue: I don't believe (but haven't looked closely) that most of these funds are even trying to gain contractual control of the deal.  They are simply writing checks with, as noted above, no real recourse in the property.

Third, and back to control, if you are in a pref equity position on a value-add property, you are not second position.  You are behind the debt, as is understood, and behind any contractor liens filed on the property.  I am not sure where insurance settlements come into play, but likely ahead of your position.  So the idea that "pref equity" without a recorded lien is protected, to me, is simply false advertising.  I would be much more apt to invest in this type of deal, if you are truly a second, recorded lien position with a fixed interest rate and a capped upside upon any capital event.

And finally, there is all the basic underwriting needs which will vary deal by deal.  How much debt is on property?  How much equity is already invested in the deal?  Where/how is this money being used?  Is this the last $5mm, or is it being invested pari passu with the common equity and being used as a "bridge loan" until they can complete raise? How do they plan on hitting NOI levels to return either there 14 or 20% annualized return for you and the common shareholders?  Does the common equity know about this capital (if not, do you want to invest and then have the sponsor subject to investor lawsuits because it wasn't disclosed)?

Jack Seiden · Answer

Nah, you could achieve similar returns with honestly the same if not lower risk, just investing in an index fund.

Paul Azad · Answer

don't want to post any of those details from their Webinar until the deal is closed, wouldn't wish to scuttle/affect their deal other than they are assuming agency fixed debt at a good rate.

but they don't mention what percentage of tenants are section 8, but do say that Sponsor has specific experience in this class of MF, don't mention if they are putting any capital into the deal nor capital call provisions, they most likely specify all that in their Offering Memorandum, which i have not requested, as I didn't think the returns quite merited the risk right now. They mention a 20% common equity tranche that is subordinate to the pref equity

Chris Seveney · Answer

You are essentially a second lien position lender.

Some questions I have are:

What I would want to know is what is the LTV on the primary loan and what are the loan terms.

When they say section 8 value add, what does that mean?

What is the total amount they are raising?

Is the GP contribution from fees or did they put capital into the deal?

What are capital call provisions? Is it only from common equity?

For 8%+ or even 10%, that seems light for pref equity behind a loan. This is just my opinion.

Preferred Equity passive investing - multi-family. Is the Juice worth the Squeeze?

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