I’m Bullish on Preferred Equity Right Now—Here’s Why

If you’ve been reading our stuff for the past year or so, you know we’re bullish on preferred equity. And we believe there is a short window of opportunity to achieve this asymmetric risk/return opportunity. 

Investors are asking a lot of questions about preferred equity, so we thought you might be interested in some details on the most recent preferred equity opportunity our fund invested in. 

As a reminder, preferred equity sits in the middle of the capital stack. It offers theoretically lower risk than equity and higher returns than debt, though it shares features of both. 

Our Most Recent Preferred Equity Deal

In December, after months of due diligence, we closed on a $4 million preferred equity investment on an Atlanta-area multifamily project. You may have heard that Atlanta was recently rated as one of America’s strongest multifamily markets.

But there are a lot of more important reasons we like this investment. This workforce housing multifamily project is being acquired by an operator with years of experience owning and operating multifamily assets in that area. The senior loan was procured through Fannie Mae at 6.61% with three years interest-only. 

Overview of the deal

Here is an overview of our preferred equity investment: 

• 9% current pay cash flow
• 8% upside accruing and compounding monthly (17% total coupon)
• Our fund held back $355,122 in current pay reserves plus $2.55 million in reserves for capital improvements.
• All reserves are held in a cash sweep account, currently earning an additional 4.5% or more. 
• Total IRR projections of 19.4% (including interest on cash sweep) 
• MOIC is projected at 1.62x over 36 months, which could be increased through early refinance.

Here are some other important considerations: 

• Current pay is senior to all other equity on distributions of cash flow after debt service.
• Full return of capital to preferred before common gets distributions from capital events.
• Full payment of all compounded accruals to preferred before common gets distributions from capital events, including return of capital.
• Pari passu depreciation with common.
• Forced sale rights to protect preferred capital and returns prior to a potential senior loan foreclosure.
• All common equity would be forfeited before the preferred capital, and full return is affected.
• Holdback of capital improvements budget to be released in draws as work is completed, per our unilateral approval.
• Annual budget approval rights.
• While we don’t technically have control rights due to FNMA requirements, the budget approval process gives our fund the “power of the purse.”

The operator plans to secure a supplemental loan in three years to take us out. We negotiated a MOIC floor of 1.50x, meaning that if we are taken out early (but there are no guarantees), we could receive an even higher annual return.  

Final Thoughts

As we’ve mentioned, these types of deals are effectively unavailable to individual investors unless you are a family office with a lot of legal and negotiating horsepower. There are some great operators providing preferred equity investment opportunities right now. But this window will likely close when interest rates drop and lender restrictions relax. 

I’d love to hear from you if you have questions.

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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, visit wellingscapital.com, 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 advisors before investing.

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