What Investors are Doing To Reduce Risk And Increase Returns By Buying Preferred Equity 

Have you seen the Woodstock for Capitalists event? It’s the Berkshire Hathaway Annual Meeting in Omaha. I watched the entire event. Charlie Munger is approaching 100 and Warren Buffett, 93. Any year could be his last.

Munger’s comments about the commercial real estate market were troubling, but not unexpected.

Munger warned that a storm was brewing in the U.S. Commercial Property Market, as American banks were flooded with bad loans due to falling property values. Buffett confirmed his fears at that time. Munger reiterated them.

Investors have been clamoring for ever-higher returns during the real estate boom. The investors asked: “How much money can I earn?”

The trend will always change. Investors are now asking “How much can I lose ?”?

Investors stop talking about returns at times like these and start talking risk-adjusted return.

Calling All Recovering Speculators

I am a recovering speculator. A few decades back, I was only concerned with returns. My firm now is obsessive about risk-adjusted return, which, in truth, is a completely different metric.

There are seasons that offer unusual deals. They are not available when profits and cash are flowing freely like the green Chicago Rivers on St. Patrick’s Day.

Moments like this are rare.

The benefits of preferred equity are numerous. They include a greater level of safety due to its higher placement in the capital stack.

This isn’t the “preferred returns” that investors get from their syndicators. It’s great but it’s not the return I am talking about.

The opportunities presented here are very different than the usual preferred equity offerings you may have received from sponsors of multifamily or other types of properties. These investments offer investors an income stream similar to debt (e.g., 8-10%) with limited or no potential upside.

Investors are willing to accept lower returns in exchange for a higher cash flow or a more secure position within the capital stack. These options are attractive and we think that now is the right time to consider them. What I am talking about is something else.

Deals Details

In an article I wrote, I made the case strongly for preferential equity. In another article, I described my reasons for the limited time frame for preferential equity transactions. Some people have requested more information on the transactions we are evaluating.

There’s no way I can explain all of them here. But I will tell you about one opportunity that we evaluated recently where the risk and potential upside are misaligned in favor of investors.

The deal helped the operator to successfully complete an acquisition.

This is one of many equity options we are currently evaluating. Below are a few details.

• Multifamily purchase with value-add, from an experienced sponsor who is located next to one of his successful current projects.
• Use 25% of common equity as an equity shield to protect preferred equity investors.
• Cash flow for current pay of 9%, reserved one year in advance plus accrued gains of 8%.
• The MOIC floor is 1.30x. This provides a minimum return of 30%, and a projected return in 18 months.
• Investors are protected by cash flow sweep rights and management control (including the ability to enforce a sale).

You wouldn’t just sign any boilerplate contract if you invested in this deal. It would be wise to engage an attorney with experience to draft documents that protect your interests and provide you rights no other investor could receive.

This is just one opportunity. This opportunity is one of many.

The risk of a capital loss is lower because the cash-flow distributions (including seepage) are given priority, current compensation reserves, and removal rights for managers.

The investment is aligned with the first priority for many BP shareholders, which is capital preservation. A second priority, predictable income. And a third, equity appreciation. This investment also passes on tax advantages from depreciation.

Please note that I am not suggesting investors give up on individual LPs. Preferred equity is a good way to diversify your portfolio.

Recenty, I spoke about one of the most sophisticated investors in our company who was able to help me understand what an extremely rare opportunity it is for people to invest.

When I explained our reasoning for investing in preferential equity, he did chide me. His gentle reproach was not directed at investing in preferred stock. He criticised me for not having invested more in preferred equity, especially in such a rare and limited window.

We see the opportunity. He sees the opportunity. We hope you will too.