The ability to achieve robust passive income with strong risk protections in place is appealing to most investors, no matter where they put their money or which methods they use.
Preferred equity investments in commercial real estate transactions and funds are an underused, but potentially reliable, way to achieve this outcome.
In fact, there has recently been increased demand for preferred equity, as real estate market activity is up, competition is increased, institutions creep into the smaller-deal size, and sponsors chase more yield—and an influx of capital to match.
That said, there are few consistent providers of preferred equity for amounts from $1 to $5 million, leaving a large segment of sponsors seeking options underserved.
This demand and lack of supply provides investors with a potentially attractive risk-adjusted return: an opportunity to gain access to transactions with the potential for upside, while structured with downside protection, through preferred equity—if they know what to look for.
Let's explore what advisors should know about small-balance preferred equity investments.
What Is Preferred Equity?
Preferred equity has historically been a vague term that has evolved over time. Essentially, it is an investment that takes priority in the capital stack after debt and insulated from loss by the common equity’s investment. In other words, investors in preferred equity receive current income, a share of the upside and downside protection through default-like covenants.
What Does the Small-Balance Space Offer Investors?
Real estate activity is moving at a faster pace than ever before in many markets throughout the country, especially as the pandemic has accelerated migration trends.
Many sponsors of small- to mid-size deals of approximately $5 million to $40 million are looking to bridge the gap between the first mortgage and the traditional syndication methods, which historically relied on friends and family, a large LP or crowdfunding. Preferred equity is emerging as a more accretive option to bridge this gap.
There are only a few reliable preferred equity sources originating $1 million to $5 million checks. That said, deals in this size range–especially those in smaller suburban growth markets, implementing value-add business plans–may still offer higher yield potential than larger, institutional real estate investments.
This short-term investment model allows investors to capitalize on current trends, rather than on future market growth, leading to immediate returns and less risk.
What Should Advisors Look For?
Because the exact role preferred equity plays in the capital stack and investment structures can vary, advisors evaluating preferred equity funds must look closely at the fund managers’ strategies, how they structure their investments with the underlying sponsor and the types of sponsors they target to determine if there is an appropriate risk-adjusted return.
When identifying a preferred equity opportunity, five key factors to look for are:
- Current cash flow paid from operations or reserves;
- A preferred priority return;
- Equity redemptions that get paid before all other equity investors;
- Participation in the profits (i.e., “equity kickers"); and
- Default covenants/downside protection.
In the small-balance space in particular, many sponsors are also looking for a capital allocator who can bring the added benefit of market experience and asset management expertise that can assist them in closing deals, optimizing management and realizing the potential value. Fund manager experience is also a key consideration for investors and advisors, as preferred equity investments are often structured with provisions to allow them to step into the equity position if the value of the property is impaired.
As it becomes more difficult to break into markets with strong growth fundamentals and secure in-demand assets throughout the country, $1 million to $5 million preferred equity investments can be just the right amount to provide the remaining financing needed and liquidity to close deals.
As a result, a well-structured preferred equity fund serving this space is a strong consideration for certain investors looking to take part in the upside of today’s active market and receive current, strong cash flow through passive real estate investment.
Eli Moghavem is a co-founder and principal of Base Equities, a national small-balance ($1 million to $5 million) preferred equity provider.