Exploring the Potential Upside in a Preferred Equity Real Estate Investment

Experiencing priority treatment as a preferred equity investor can be likened to strolling down the red carpet at a glamorous Hollywood event. Just like having your car door opened for you and casually strutting into a VIP-style occasion, as a preferred equity investor, you occupy a prestigious position in the capital stack, enjoying a secure and fixed monthly payment. Meanwhile, other investors must wait for their payments, akin to eager guests waiting in line to enter the Hollywood event.

Moreover, knowing that a portion of your fixed interest payment is accumulating and compounding over time adds to the growth of your earnings. Receiving the upside payment at the end of the deal is akin to winning the award for the Most Risk-Adjusted Investment of the Year, signaling that your investment decisions are astute and prudent.

To elucidate how a preferred equity investment provides both monthly cash flow and an upside payment in a low-risk manner, this article delves into an example. It introduces new terminology to aid in comprehending the origins of returns in a preferred equity investment and discusses how this impacts the equity multiple of the deal.

What Is Preferred Equity Investing?

Preferred equity (or pref equity) involves injecting capital into a commercial real estate investment. Distinct from a typical investment from a limited partner, pref equity capital is directed towards a higher position in the capital stack than common equity capital. As the name implies, preferred equity provides investors with a priority seat in the capital stack, resulting in payment before common equity investors, thereby reducing risk. Pref equity serves various purposes in the acquisition and ownership process, filling funding gaps during acquisition or infusing capital into the middle of a deal. With current lending restrictions, this type of preferred equity becomes increasingly vital for syndicators, particularly in refinancing scenarios. Further details and examples are explored in our dedicated preferred equity investing article, where we delve into the specifics of both monthly returns and the final upside payment in a preferred equity investment.

Variables Influencing Equity Multiples in a Preferred Equity Investment

Although the overall interest rate and current pay rate are predetermined when entering a preferred equity investment, four variables play a role in influencing the total equity multiplier of the investment. The equity multiple serves as an effective metric for gauging the potential returns from investing in a deal.

The equity multiple represents the factor by which your money or equity will be multiplied over the anticipated ownership duration, or hold time. A 2.0x equity multiple, for instance, indicates a doubling of the original investment within the specified hold period.

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

#1: Preferred Equity Investor Class

Different investor classes receive varying shares of the earnings generated from the preferred equity investment. A typical breakdown of investor class shares could be structured as follows:

Observing the allocation across investor classes, it’s evident that the current cash flow (or current pay) remains consistent. However, the accrued cash flow (or accrued pay) demonstrates an augmentation with an increased investment amount, correlating with a rise in the projected equity multiple.

#2: Overall Interest Rate

A higher overall interest rate translates to elevated current pay and accrued pay. This negotiation occurs before presenting a deal offering to investors, emphasizing our commitment to securing the most advantageous rates for our investors.

#3: Compounding

Compounding interest, a recognized financial strategy, contributes to accelerated wealth growth. While passive real estate investing often doesn’t employ traditional compounding, the accrued pay in preferred equity involves interest on interest. For instance, a $100k investment with a 5% accrued pay interest rate in year 1 accrues $5,000. In year 2, this rate is applied not only to the initial $100k but also to the $5k earned, fostering exponential growth over the term.

#4: Term

In a preferred equity investment, an extended term leads to a higher equity multiple due to the continuous compounding of accrued pay. For instance, a $1M investment in preferred equity (Class C split, as outlined in our investor class example) yields a total accrued pay of $167,178 and an average accrued return of 5.57% if a payout occurs in year 3. Extending the hold until year 7 boosts the accrued return rate to 6.32% through compounding.

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.