SS112: Preferred Return vs Preferred Equity

SS112: Preferred Return vs Preferred Equity

Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing Preferred Return versus Preferred Equity.

Over the years, real estate syndication structures have become more and more sophisticated, with more and more terms being used to describe how returns will be distributed to investors. In this episode, Charles discusses the difference between a preferred return and preferred equity.

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Talking Points:

  • Over the years, real estate syndication structures have become more and more sophisticated; with more and more terms being used to describe how returns will be distributed to investors.
  • What is a preferred return?
    • A preferred return is a preference in the returns on capital investment. It refers to the order in that returns are distributed to investors from an investment. This priority in distributions is maintained until a predetermined rate of return is achieved. Once the threshold is met; distributions are made to other subordinate investment stakeholders.
      • For example; if you invested into an investment with an 8% preferred return and then a 70/30 split afterward; once your 8% rate of return is achieved; distributions above the 8% are now split 70/30 with investment stakeholders behind you; such as; the general partners.
    • What is preferred equity?
      • In a preferred equity investment, an investor gets their initial investment back along with a predetermined rate of return BEFORE any of the other investors are paid. In other words, preferred equity refers to a specific position in the investment that is senior to common equity (aka other investors) BUT is subordinate/behind the debt.
        • For example; an apartment investment company is buying a $20 million apartment complex. Let’s say that they are financing $14 million of it. $6 million of equity is then required to close. The investment company is raising $3 million dollars from their investors and themselves, and that leaves $3 million dollars that are required to close. They might approach a private equity firm for the $3 million dollars and the firm will say sure, but they want their $3 million to be preferred equity. In other words; after the mortgage is paid; they are paid. They are paid before any other investors, and they are paid before the operators are paid AKA the apartment investment company. The private equity firm is typically entitled to both their return of capital invested (their principal) and a fixed rate of return before any capital is returned to the sponsor and other equity investors. This fixed rate of return usually varies from 9%-12%. This is a very typical structure for private equity firms and family offices.
      • What are the benefits of a preferred return?
        • As an investor; it shows that the operator is confident enough with the investment to pay you a predetermined rate of return before they receive any returns.
      • What are the benefits of preferred equity?
        • For the private equity firm providing the preferred equity funds; they are receiving a fixed rate of return (that might be lower than other investors) however; it is paid out before any of the other investors. This makes their position much safer.
        • For the apartment investment company; yes, they will be paid behind the preferred equity and also behind their investors; but they only need to raise a proportion of the equity from themselves and their investor base. It is minimizing hassles by simplifying tax time for the company in addition to minimizing the time required to correspond with potentially 60 investors who could have invested $50k each to reach the same $3 million amount offered by the private equity firm. It is much easier to bring in 1 big partner compared with 60 small ones.
        • It benefits the investor, the limited partner because your return will be amplified since you are paying less money for the preferred equity; it is almost like an extension of debt. If you have a 70% loan to value; at a rate of 6% and you are paying a rate of 12% to the preferred equity investors and they are funding another 15% of the purchase; so we are at 85% right now funded; the operators and individual investors are funding only the last 15%; effectively paying a rate of less than 7.25% to finance the whole deal; and operators and individual investors keep all of the upside.
        • Preferred equity is less risky for the investor but also has a lower return. Definitely, a staying wealthy strategy versus a getting wealthy strategy; no wonder it is most utilized by private equity firms and family offices.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing Preferred Return versus Preferred Equity.

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Charles:
Over the years, real estate syndication structures have become more and more sophisticated with more and more terms being used to describe how returns will be distributed to investors. So what is a preferred return? Well, a preferred return is a preference in the returns on the capital investment. It refers to the order that returns to the distribute to investors from an investment. This priority in distributions is maintained until a predetermined rate of return is achieved. Once the threshold is met, distributions are made to other subordinate investment stakeholders. For example, if you invest it into an investment with an 8% preferred return and then a 70 30 split afterwards, once your 8% rate of return is achieved, distributions above the 8% are now split 70 30. With investment stakeholders behind you, such as the general partners, what is preferred equity? Well, in a preferred equity investment, an investor gets their initial investment back along with a predetermined rate of return before any of the other investors are paid. In other words, preferred equity refers to a specific position in the investment that is senior to common equity, aka other investors, but is behind the mortgage.

Charles:
For example, an apartment investment company is buying a 20 million apartment complex, and let’s say they’re financing 14 million of it. So 6 million of equity is then required to close on the property. The investment company is raising 3 million from their investors and themselves, and that leaves $3 million that is required to close on the property. They might approach a private equity firm for the $3 million, and the firm will say, sure, but they want the $3 million to be preferred equity. In other words, after the mortgage is paid, they’re paid. They’re paid before any other investors, and they’re paid before the operators are paid, AKA v Apartment Investment Company. Now the private equity firm is typically entitled to both the return of capital investment, their principle, and a fixed rate of return before any capital is returned to the sponsor and other equity investors, this fixed rate of return usually varies from 9% to 12%, and this is a very typical structure for private equity firms and family offices.

Charles:
So what are the benefits of a preferred return? Well, as an investor, it shows that the operator is confident enough with the investment to pay you a predetermined rate of return before they receive any returns themselves. So what are the benefits of preferred equity? Well, for the private equity firm providing the pri, the preferred equity funds, they are receiving a fixed rate of return that might be lower than other investors. However, it is paid out before any of the other investors. This makes their position much safer for the apartment investment company. Yes, they’ll be paid behind the preferred equity and also behind their investors, but they only need to raise a proportion of them equity from themselves and their investor base. It is minimizing hassles by simplifying tax time for the company. In addition to minimizing the time required to correspond with potentially 60 investors who could have invested $50,000 each to reach the same $3 million amount offered by the private equity firm, it is much easier to bring in one big partner compared with 60 small ones.

Charles:
It benefits the investor, the limited partner, because your return will now be amplified since you are paying less money for the preferred equity, and it is almost like an extension of debt. If you have a 70% loan of value at a rate of 6% and you’re paying a rate of 12% to the per preferred equity investors, the private equity firm, and they are funding say another 15% of the purchase. So we are at now 85% right now funded. The operators and individual investors are funding only the last 15%, effectively paying a rate of less than 7.25% to finance the whole deal, and operators and individual investors keep all of the upside. Now, preferred equity is less risky for the investor, but also has a lower return, definitely a staying wealthy strategy versus a getting wealthy strategy. No wonder it is utilized by private equity firms and family offices. So I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show [email protected]. Look forward to two episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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