What is the Upside Potential In A Preferred Equity Real Estate Investment?

Getting priority treatment as a preferred equity investor feels like strolling down the red carpet at a glamorous Hollywood event. Your car door is whisked open and you casually strut into the big event in VIP-style. 

This is because as a preferred equity investor you hold a prime position in the capital stack with a secure and fixed payment delivered every month. Other investors must wait for their payment, somewhat like the eager guests waiting in line to get into that Hollywood event. 

On top of that, you know that a portion of that fixed interest payment is being accrued and is compounding over time to further grow your earnings. Receiving this upside payment at the end of the deal is like winning the award for Most Risk-Adjusted Investment of the Year – a coveted signal that you make discerning and wise investment decisions.

To help you understand how a preferred equity investment provides monthly cash flow as well as an upside payment (or final payout of accrued interest) in a low-risk way, we’re going to dive into an example in this article. We’re also going to present some new terminology to help you understand where your returns come from in a preferred equity investment. Finally, we’ll discuss how this all impacts the equity multiple of the deal.

Quick Preface: What Is Preferred Equity Investing?

Preferred equity (aka, pref equity) is an infusing of capital into a commercial real estate investment. The difference between a typical investment from a limited partner (like you are me) is that this capital goes into the common equity position in the capital stack and preferred equity capital, or investments, go into a higher position in the capital stack. 

As the name implies, preferred equity provides real estate investors with a priority seat in that capital stack over the common equity investors. This means that preferred equity investors get paid before common equity investors, thus decreasing the risk to the preferred equity investor.

Pref equity is used at different stages of the acquisition and ownership process. Sometimes a preferred equity investor (a group or an individual) comes in to fill a funding gap during acquisition. Other times, preferred equity is needed to infuse capital into the middle of a deal. With the current market’s lending restrictions, this is the type of preferred equity that is becoming more and more important for syndicators to use, such as in the case of a refinance.

We dive into examples of how this looks, as well as answer more questions in our preferred equity investing article. In this article, we’ll dive deeper into where both the monthly returns and the final upside payment come from in a preferred equity investment.

Related Article: Preferred Equity Real Estate Investing – What Is Pref Equity And Is It Right For You?

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How Does Cash Flow Work In Preferred Equity: Current Pay and Accrued Pay

One of the biggest ways risk is mitigated in a preferred equity investment is through a fixed monthly payment based on an interest rate that is paid before any other investors get paid in the deal.

This interest rate is called the overall interest rate, which is determined when the deal goes under contract. The sponsor (the owner/operator of the asset) agrees to pay the preferred equity investors (that’s us) this fixed rate, which may be 14% – 16%. The sponsor is agreeing to pay the preferred equity investors that rate until they pay off the the entire amount we’ve invested. We call this the final payout. 

However, the sponsor doesn’t pay the full interest amount every month. This overall interest rate is broken down into two types of payments: monthly cash flow from the current pay and the upside returns from the accrued pay.

Monthly Cash Flow From Current Pay In Preferred Equity

The current pay is the portion of the total interest rate payment that the sponsor agrees to pay on a monthly basis. This may be in the 6% – 9% range.

Let’s say the current pay to investors is 6.75%. In the graphic below, we can see how that 6.75% interest provides an investor $6,750 every year, or $562.50 every month, based on a $100k investment (class A). This investor receives this payment before anyone else in the deal, including existing limited partner investors.

(If you’re like us, it may feel strange to cut in line here, especially if you are a limited partner on other deals. However, when done right, preferred equity investments can make the entire deal even better in the long run so that everyone can see a great return on their investment.)

Another note is that in some deals, the current pay also compounds over time to increase the final upside payment further. This is not the case in every preferred equity deal because of the different criteria in place by the senior debt holder. 

 

Current Pay vs Preferred Return

The current pay may sound like a preferred return. There are two differences between the monthly cash flow from current pay and a preferred return distribution on a typical syndication investment. 

First, the current pay is paid to investors before the preferred return is paid out. If there is cash flow left over, then the limited partners in the deal will get their preferred return. 

Second, a current pay payment is based on a fixed interest rate and won’t fluctuate depending on the cash flow of the deal. A preferred return distribution may be lower than the actual preferred return rate (with the difference accruing until cash flow is sufficient), but a current pay payment has to be paid in full each month. 

This means that the current pay payment amount will not go down. If it does, the preferred equity investors technically reserve the right to take ownership of the property (another reason the risk is lower).

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Upside Returns From Accrued Pay In Preferred Equity

The remaining difference between the overall interest rate and the current pay rate is the accrued pay. This amount will accrue and compound over time. This is the total interest rate minus the current pay rate. 

In our example above of a $100k investment, the accrued pay in year 1 is $4,317. That amount begins to compound. Every year, more accrued pay is earned and continues to compound. By year 7, the annual accrued pay has increased to $6,183. 

At the end of the deal, preferred equity investors receive their accrued pay as a lump sum payment, as well as the return of their original capital. This is the upside in a preferred equity investment.

This occurs when the sponsor decides to pay off the preferred equity investors. This could be using capital from a refinance or the sale of the asset. The sponsor can pay off the preferred equity investors once the minimum hold period has passed, typically 2-3 years. However, the longer the preferred equity is held, the more time compounding can work its magic to increase investor’s earnings.

 

Upside Payment Returns vs Proceeds From Asset Sale

The accrued payment may sound similar to the payment received from the proceeds of the sale in a typical commercial real estate syndication. The difference is that the typical upside return from a common equity position (or as a limited partner in a syndication) is unknown. 

Projections can be made about where the market may be in the future and how much value the property could have by then, but the final sale price can’t be known until the final sale contracts are signed.

The accrued pay amount is based on an overall fixed interest rate and not based on the current market conditions. 

The accrued pay upside return in a preferred equity investment is a known interest rate (total interest rate minus current pay rate is the accrued pay rate). This amount compounds over time and is then paid in full as the upside return at the end of the investment. The longer the investment is held, the more the accrued pay will be due to increased time compounding.

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Current Pay + Accrued Pay

While we it may be simple to think of the overall interest rate being split into two separate payments (the current pay and the accrued pay), the math isn’t as simple as 5 + 5 = 10. Each investor class has a different split of these payments, similar to the share of payments in a typical syndication structure. 

Additionally, the accrued interest rate will increase every year due to the additional earnings from compounding.

In the example we’ve shown above, we’ve outlined the returns that will go back to the investor, after all these calculations have already been made. This is why it is difficult to show a simple current pay rate and a simple accrued pay rate that equals one total interest rate.

 

What Variables Impact Equity Multiples In A Preferred Equity Investment?

While the overall interest rate and the current pay rate are known going into a preferred equity investment, four variables can impact the investments’ total equity multiplier. The equity multiple is one of the best ways to quickly understand how much money you stand to make by investing in a deal. 

The equity multiple is the amount that your money, or equity, will be multiplied by over the projected ownership time, or hold time. Thus, a 2.0x equity multiple means you would double your original investment amount in the given hold period. 

The four variables that impact a preferred equity investor’s equity multiple are investor class, overall interest rate, compounding, and length of time the investment is held (term).

#1: Preferred Equity Investor Class

Each investor class has a different share of the earnings from the preferred equity investment. For example, a typical breakdown of investor class shares could look as follows:

We can see that the current cash flow (or current pay) is the same across investor classes. However, the accrued cash flow (or accrued pay) increases with an increased investment amount. This corresponds to an increase in the projected equity multiple.

#2: Overall Interest Rate

If the overall interest rate is higher, then both the current pay and the accrued pay can also be higher. This is done during contract negotiations before a deal offering is presented to you, the investor. Just know that we’re always looking for ways to get the best deals for you, which means getting this rate as high as possible.

#3: Compounding

If you’ve spent any time learning about personal finance, you’ve certainly heard about the magic of compounding interest. In passive real estate investing, we don’t often use this type of financial strategy to grow our money. While we talk about the power of reinvesting our earnings (regular distributions, proceeds from the asset sale, etc) into new deals to grow your money faster, this isn’t technically compounding.

Compounding is essentially interest on interest, which grows money at an accelerated rate. In a preferred equity investment, that means that if you invest $100k and your accrued pay interest rate in year 1 is 5%, you would accrue $5,000. Then in year 2, your accrued interest rate is again applied to your $100k and also applied to the $5k you just earned. You’re earning on your earnings. This is where the term, or hold period, comes into play.

#4: Term

The longer the term, the higher your equity multiple in a preferred equity investment. This is because your accrued pay is continuing to compound every year. 

In the scenario below of a $1M investment in pref equity (which is a class C split of profits in our investor class example above), we can see that if we were to receive a payout in year 3, we would earn a total accrued pay of $167,178, which is a 5.57% average accrued return (in addition to our annual current pay return). 

However, if we hold until year 7, our accrued return rate increases to 6.32% because of compounding.

Conclusion

While the terms used in a preferred equity investment are different, there are many similarities to typical real estate syndication investments. However, behind these new terms and different structure for delivering returns is multiple forms of risk mitigation. 

Sitting higher in the capital stack and having a fixed rate of return every month make preferred equity investing a very reliable source of cash flow in today’s market. However, it is also important to remember that there is a final payout very similar to the upside potential we all hope for in real estate investing. Except in preferred equity, it is also part of a fixed interest rate.

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You can also check out our open deals page to learn more about our current or upcoming opportunities.

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