My kids’ opinions about what to do on a day off of school is shaping up to be dramatically different.
My son, just 20 months old, already senses that his bike is just beyond the barrier of the front door and he wants out at all costs. 30-degree temperatures? No problem – I’m sure my mom will put a jacket on me. Massive hills at the edge of the driveway? Who cares – I’ve got this bulky helmet on.
He’s taking on the risks of failure with ease and perhaps a little too much enthusiasm than mom would like.
Then there is his 5-year old sister. She sees the wind blowing in the trees and just begins to draw at her art table. Even if mom forces warmer clothing, socks, shoes, a jacket, a hat, and other terribly inconvenient items upon her, she may only ride her bike down the sidewalk until she sees the perfect fairy-house building materials and will immediately pivot.
Both ended up taking on the risk they were comfortable with and ended up with a fine activity (although mom is now being pulled in different directions, but that’s part of the job description).
Our risk appetite can help us push out of our comfort zone into new realms, as well as protect us from getting seriously hurt. At Goodegg, we’ve been immersing ourselves in the new opportunity of Preferred Equity investing, and have decided that the increased elements of risk mitigation make this opportunity incredibly valuable given the current market conditions.
In this article, we’ll dive into the potential risks in preferred equity investing, and present our
Top 7 risk mitigation strategies for every preferred equity deal we offer.
First, What Is Preferred Equity?
Preferred equity is an equity investment in real estate that sits right below the lender in the capital stack and before the common equity. This means that preferred equity investors get paid right after the lender gets paid. While this type of investment is not technically debt (that’s the loan from the lender), it is sometimes confused with debt because the earnings are based on a fixed interest rate, rather than the performance of the asset.
A deal may incorporate preferred equity for a variety of reasons. Sponsors may bring in preferred equity immediately when purchasing a deal to fill a capital gap, or they can insert preferred equity into the deal after the deal has been under operation.
Goodegg Investments has worked with preferred equity investment groups in the past and used this type of capital to purchase many assets. It’s not new in commercial real estate by any means.
The difference is that now we’re able to be the preferred equity providers that bring capital into other deals in this priority position. The increased need for owners to refinance or recapitalize assets already under management means that there is a great opportunity to provide smaller amounts of capital (in the $2 million to $5 million range) into deals as pref equity. Traditional preferred equity investors typically don’t do anything below the $10 million threshold.
With every market needs comes an opportunity.
The type of preferred equity investing that we’ll be presenting in this article involves placing our capital into a property that has already been acquired by another group, as opposed to a new acquisition. Our criteria for selecting a preferred equity investment placement is the same as if we were going to purchase the property outright.
What Are The Risks When Investing In Preferred Equity?
With any investment, there is always a risk. Whether it is investing in real estate, the stock market, cryptocurrency, etc, there is always risk of capital loss.
In passive real estate investments, the risk is limited to the amount of money you’re investing in that deal. However, some deals provide more ways to mitigate the risk of losing money.
Let’s take a look at some risks in getting your money working in passive real estate, with a focus on risks in preferred equity investing specifically.
Risk #1: Investing In Distressed (or Underperforming) Properties
Some preferred equity is deployed to purchase a distressed property, often with the goal of bringing it back up to par.
However, properties that aren’t performing well often have underlying problems that may or may not be really big problems (that can’t be resolved). Sometimes the market isn’t supporting the type of rental growth forecasted for the property to do well. Sometimes the operations team ran the asset so far into the ground that it would take too much money to revive.
We mitigate this risk by simply not investing in distressed properties. This is not where our expertise lies and there is too much risk exposure for our comfort levels.
This doesn’t mean that these types of deals can’t provide great returns sometimes – just like gambling can create wins sometimes. We find, however, that distressed asset investing relies on too many external factors that can’t be well managed or controlled.
Risk #2: Your Ownership Is Not Tied To The Property Value
While the addition of pref equity can help to bolster the long-term profitability of the asset, pref equity investors don’t directly benefit from that increase in property value. We make our money on the interest (which is risk mitigation strategy #1). If the property miraculously triples in value, we don’t see any of that gain in our final upside payout. This structure prevents the limited partner investors from getting diluted out. We, of course, still get our planned upside payment from our compounding interest, and the limited partners get their great upside return from the proceeds of the sale. It’s actually a win-win in that way.
The risk here is not making out-of-this-world returns, but rather pretty-awesome-fixed-rate returns.
Risk #3: Your Capital Is Illiquid
Your capital is not liquid in a pref equity investment, just like any passive real estate investing deals we offer. This is true for nearly every type of real estate. If you need your capital to remain in a liquid state – or for it to become liquid in less than 5-7 years, then real estate probably isn’t the best investment vehicle for you.
Risk #4: Your Capital May Be Returned Sooner Than 5-years
A sponsor may decide to pay back all preferred equity investors at the earliest possibly opportunity they have. Our contract stipulates a minimum hold period, often 2-3 years. If the sponsor pays us off sooner, they agree to pay us a minimum return, or an early payment fee.
You may wonder why getting your capital plus returns back sooner is a risk. Well, many investors want their money working for longer periods of time. Having your capital returned means you have to find somewhere else to get it working again sooner than expected. In pref equity, it also means less time for our interest payments to compound.
How Is Risk Mitigated In A Preferred Equity Investment?
Preferred equity investing has lower risk than most passive real estate investments in syndications. Let’s dive into the top ways your risk is reduced with a preferred equity investment.
Risk Mitigation #1: You Get Paid First
The biggest risk mitigation for your preferred equity investment is where we sit in the capital stack. Because we get paid before all other investors in the deal, there is a greatly reduced risk that you will lose any money, or not see your regular monthly cash flow.
In this way, the preferred equity position is treated very similarly to the bank’s position (and the bank always gets paid). Our contract stipulates that the deal sponsor must pay us a fixed current pay amount (or a specified portion of our total overall rate) every month. They aren’t allowed to pay us a portion of this or miss a single payment, which leads us to mitigation layer #2.
Risk Mitigation #2: We Can Take Full Ownership If We Don’t Get Paid Every Month
If the sponsor misses even a single payment or doesn’t fully pay us the agreed-upon current pay rate (which is a pre-determined portion of the overall interest rate – like 6% or the total 14% we’ll receive by the end of the deal), we can technically take full ownership of the property.
Risk Mitigation #3: We Know Our Cash Flow Amount For The Full Hold Period
In a traditional passive real estate investment, investors may have a preferred return rate, which they are paid when the property is cash-flowing. However, it is common that a portion of that preferred return begins to accrue (or will be distributed at a later date) from day 1. This means that while an investor may have a preferred return of 7%, they may only receive 2% of that for the first few years. Or less.
In preferred equity investing, we know exactly the amount of cash flow we’ll get. And, we get that cash flow monthly (not quarterly). This means that you can count on the passive income stream from regular distributions in preferred equity to be there more than other passive real estate investing income from distributions.
We also know what our minimum upside payment (our final payment, similar to the upside from the sale of an asset) will be when we sign our contract.
Our fixed overall interest rate is broken into a current pay (monthly cash flow) and an accrued pay rate (final upside payment). We know these rates when we submit our investment funds. If the overall rate is 14% and the current pay rate is 8% of that overall rate, that leaves 6% which will be our accrued rate.
Since our accrued payments will compound over time, our rate will grow. This is the minimum This means that the accrued interest rate will be higher, depending on the length of time we are in the deal.
Finally, our upside potential is not tied to the value of the property. This mitigates the risk of the property only increasing in value a small amount in this market cycle – or not at all. We get the same rate as we determined from the beginning of the deal.
Risk Mitigation #4: We Invest In Strong Performing Assets
As we cited above, investing in distressed properties (or under-performing) comes with extra risk. This is why we only invest in strong, performing assets as preferred equity. This means that there is existing cash flow and the property is in great shape.
Assets that have high occupancy numbers, no deferred maintenance, and smooth operations tell us that the underlying value of the asset remains high. It also tells us that the sponsor, our partner, is doing their job well.
Risk Mitigation #5: Our Partners Have Strong Track Records
The sponsors we’re partnering with have successfully completed exits in other properties with similar characteristics as any deal we’re underwriting. We want to see a strong track record of success with similar business plans in similar markets. These aren’t the operators who just got started acquiring and managing commercial real estate assets.
Risk Mitigation #6: We Limit Financing Up To 75% – 80% LTV
The Loan-To-Value (LTV) ratio tells us how much lending risk is on a property. The rate is calculated by taking the total amount of debt and dividing it by the appraised property value. For example, if you buy a home appraised at $300,000 for its appraised value, and make a $30,000 down payment, you will need to borrow $270,000. This results in an LTV ratio of 90% (i.e., $270,000/$300,000).
Risk increases with a higher LTV because a lender may have a harder time selling a property in the event of a foreclosure and covering the outstanding loan balance.
We only enter into a pref equity investment deal if our LTV ratio is 80% or lower. We look for deals where the LTV would be 75% after our pref equity is placed, but could go up to 80% if we’re seeing very strong cash flow. This ensures that there isn’t too much total debt placed on the property, or that we aren’t “over-leveraged.”
Risk Mitigation #7: We Know The Markets And We Know Multifamily
With over 20 strong exits in multifamily assets across the Sun Belt market, and several others currently under management, we have a strong familiarity with the markets where our preferred equity will be placed. This gives us great expertise and confidence in the business plans behind those investments.
We have also done asset management in multifamily for years and can deeply evaluate these opportunities. We also only invest in assets that we’d buy directly given the chance.
This means that these opportunities are our bread and butter. Or rather, our egg souffle.
Related Video: Goodegg Live – What is Pref Equity?
Our Big Goal With Every Investment
With every deal we do, we only move forward if it looks like everyone can win.
We know, this likely sounds idealistic and probably a little sappy. But we know it is possible. We may look for deals where our investor group stands to receive outsized returns, we would never enter a deal that we thought would put anyone in the hold.
This means that by inserting preferred equity into a deal, we help improve the value of the asset for everyone.
And in this market of high inflation and very few deals that pencil out, we’re liking preferred equity’s increased risk protection even more.
If you’re looking to invest in real estate syndications with strong asset management practices, we invite you to join the Goodegg Investor Club, so we can keep you in the loop on opportunities to invest alongside us.
You can also check out our open deals page to learn more about our current or upcoming opportunities.
If you’re not yet ready to invest but are curious about how all of this works, we invite you to dip your toe in the water with us through our free 7-day email course – Passive Real Estate Investing 101 – or to get a copy of our book – Investing For Good.
To learn more about us and our experience, be sure to download a copy of our track record, which shows the projected and actual returns we’ve achieved across all the deals we’ve exited to date.