A Deep Dive Into the Nitty-Gritty Details of Preferred Equity

Have you seen our discussion on preferred stock? This raises some questions regarding deal structure and terminology, and a desire to see some examples. We discussed the issue of preferred stock. And why is the time frame limited here? Additionally, we outlined recent preferred stock transactions. last article.

I’ve covered a lot, but I haven’t provided all the basic terminology that investors need to understand all these trades.

BiggerPockets has long served as an educational site. As a result, you may be interested in details that have little or no interest to the average real estate investor. This is one of those opportunities.

So, in this post, I will take some time to commercial real estate Preferred stock investment. But I’m not going to bore you with just the definition. Let’s explain this term and how it works in actual preferred stock investing.

Terms and investment

The opportunity was a $3.5 million preferred equity investment in the acquisition of a value-add multifamily project with an experienced sponsor in the Virginia Beach area. We’ll give our definition and then explain in italics how the term works for this investment.

Current salary rate

The portion of the coupon rate paid by management.

The current salary rate is 9%. This current salary is actually paid in advance for a year, and the retained funds can be invested in U.S. Treasuries, which currently pay about 5%. This could increase the potential return on this investment.

Accrual amount

The unpaid portion of the coupon rate paid on a capital event.

Earns compound interest of 8% per year. (The total of current salary and accrual amount is 17% coupon rate.)

personal guarantee

A contractual guarantee by a sponsor or major principal to cover preferred stock in the event of default. This is similar to a full recourse personal guarantee on a loan.

Personal guarantees will be signed by the three principal sponsors for this investment.

forced sale clause

The rights of the preferred equity partner to affect the marketing and sale of the asset if the default clause is triggered.

A forced sale clause in this investment allows the investor to force the sale of the asset if certain terms (reserves, debt service coverage ratio, etc.) are not met. To protect their position, preferred stock investors could theoretically force a potentially damaging sale of common stock.

Summary of cash flow

The Preferred Equity Partner’s right to all cash flows from operations until the cash flows fully cover current payroll, a predetermined global DSCR is achieved, or the Preferred Equity Partner is repaid.

Sponsor has agreed to this backup reserve account. This prevents cash flow from operations from being accessible to the sponsor until certain hurdles are crossed.

capital reserve

Funds allocated for capital improvements are held by preferred equity partners and released in a lottery based on progress. In some cases, lottery approval may require previous improvement results in terms of rent increases or expense reductions.

This investment reserve account puts the responsibility of implementing the plan on the sponsor. But returns could also be compounded, as they could be invested in U.S. Treasuries, which could contribute about 5% to preferred investors.

MOIC floor

Also known as minimum multiple. Minimum multiple of invested capital. Triggers if the preferred stock is paid off before its multiple is achieved by the coupon rate. This is similar to a prepayment penalty on a loan.

The MOIC floor for this investment is 1.30x, which equals 30% of the total minimum return. If the sponsor repays the preferred stock on schedule within 18 months, it will earn an annualized return of 20% (rather than the 17% coupon rate).

If you would like a further definition of preferred stock, please visit: Preferred stock page on my website.

conclusion

Many investors are happy to have access to investments like this during this strange time in the economic cycle. These investments are generally difficult to access for retail investors and theoretically offer low risk, solid cash flow, and high annual gross returns.

We welcome your comments and questions regarding preferred stock and other matters.

Note by BiggerPockets: These are the opinions expressed by the author and do not necessarily represent the opinions of BiggerPockets.