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  • What is Preferred Equity?

    Commercial Real Estate (CRE) Investor Question #86: What is preferred equity and should I invest in preferred equity?

    We’ve seen the CRE capital stack in a previous post and how preferred equity is a part of it. We’ve seen that preferred equity is a debt/equity hybrid that resides in the third position of the capital stack.  It is more senior than common equity but less senior than all forms of debt (Senior and Mezzanine).

    It is important to understand the risk and characteristics of preferred equity compared to the rest of the stack. PropertyMetrics explains preferred equity in detail and compares it to the rest of the capital stack.

    Risk level, repayment prioritization, and return expectations:

    Risk Level:Medium – High
    Repayment Prioritization:3rd
    Return Expectations:8% – 10% + “Kicker”
    Source: https://propertymetrics.com/blog/capital-stack/

    Characteristics of Preferred Equity

    Further explanation of preferred equity can be found in the same article. We highly recommend going through the entire article and getting familiar with the capital stack and preferred equity in particular.

    Preferred equity serves a similar function to mezzanine debt in that it is meant to fill the gap between senior debt and common equity

    In return for the risk associated with making a preferred equity investment, the investor is compensated with a steady return in the form of annual payments (like debt) as well as an opportunity to participate in the upside of the project should it meet certain performance goals (like equity).  

    The performance goals are clearly outlined in the investment contract and typically establish a threshold, above which an equity “kicker” allows the preferred equity holder to participate in additional profits.

    Source: https://propertymetrics.com/blog/capital-stack/


  • What is Preferred Equity?

    Commercial Real Estate (CRE) Investor Question #86: What is preferred equity and should I invest in preferred equity?

    We’ve seen the CRE capital stack in a previous post and how preferred equity is a part of it. We’ve seen that preferred equity is a debt/equity hybrid that resides in the third position of the capital stack.  It is more senior than common equity but less senior than all forms of debt (Senior and Mezzanine).

    It is important to understand the risk and characteristics of preferred equity compared to the rest of the stack. PropertyMetrics explains preferred equity in detail and compares it to the rest of the capital stack.

    Risk level, repayment prioritization, and return expectations:

    Risk Level:Medium – High
    Repayment Prioritization:3rd
    Return Expectations:8% – 10% + “Kicker”
    Source: https://propertymetrics.com/blog/capital-stack/

    Characteristics of Preferred Equity

    Further explanation of preferred equity can be found in the same article. We highly recommend going through the entire article and getting familiar with the capital stack and preferred equity in particular.

    Preferred equity serves a similar function to mezzanine debt in that it is meant to fill the gap between senior debt and common equity

    In return for the risk associated with making a preferred equity investment, the investor is compensated with a steady return in the form of annual payments (like debt) as well as an opportunity to participate in the upside of the project should it meet certain performance goals (like equity).  

    The performance goals are clearly outlined in the investment contract and typically establish a threshold, above which an equity “kicker” allows the preferred equity holder to participate in additional profits.

    Source: https://propertymetrics.com/blog/capital-stack/


  • Risks faced by a CRE Investor?

    Commercial Real Estate (CRE) Investor Question #85: What are the various risks faced by a CRE investor?

    Investing is all about risk vs reward and managing the risk to protect capital and returns. It is true for Commercial Real Estate (CRE) investing as well. Here are the major risks faced by a CRE investor:

    • Market Risk
    • Property Risk
    • Credit and Debt Risk
    • Liquidity Risk

    A detailed description of the above is available at Embroker’s real estate risk managment blog.

  • What exactly does an investor do?

    Whether investors like it or not, investing may be considered as a “lifestyle” job and may not get recognition for the hard work that goes into it. As an investor, don’t underestimate the investing process, the work involved, and above all your self-worth!

    If you were to go by general media, investing may come across as one of the easiest jobs on the earth. Popular culture doesn’t necessarily associate investing activities with skill or hard work. Moreover, the association with money may even lead some to think that investing is bad or greedy. Depending on personal situations, some tend not to have positive associations when it comes to investing.

    Before we look at society’s take on investing, what is your personal take on investing? Is it positive or negative? It is great if you have a favorable opinion on investing. Congrats! If you don’t have a favorable opinion of investing, there is some work to do. Because that is a big hurdle we need to overcome. Hope this article helps serves as an encouragement to many. We will address head-on the stereotypical take on investing and help wannabe investors overcome any negative thinking.

    How does the world see investors?

    For the most part, the world (i.e. primarily your family and friends) may see investing as an activity to multiply money i.e. becoming rich. The focus is on the results, becoming rich, then the process itself. The world may look up to rich people as aspirational, but still, the investors don’t get much love.

    If you’re an investor, should you worry about what the world thinks of investing? Not really. The real question is do you enjoy the investing process or work? Do you find it challenging? Like becoming a pro athlete, becoming a good investor is no small thing. Only the good ones succeed in the long run.

    If you listen to a leader in any field, one of the biggest aspects of success is working hard and long. The common lore is also that hard work and persistence lead to great success. It is tough not to agree, but what exactly is hard work in today’s age? In the decades past, a farmer who works in the field 10+ hours a day would be hard work. A factory worker working 10+ hours a day would be hard work.

    Historically, humans have been laborers or workers working in the field or factory for the entire day. Physical work was associated with hard work and is associated to this day. The physically demanding work is clearly attributed to hard work. But, what is hard work in today’s non-agricultural economy? Let us go through a few examples:

    • A Singer who creates music and works on it for 10+ hours a day in her studio. Is that hard work?
    • A Writer who writes a book working on it 10+ hours a day sitting at his computer. Is that hard work?
    • A Doctor seeing patients in his office for 10+ hours a day. Is that hard work?

    If you believe any of the above is hard work, then without doubt investing is also hard work. Investing involves a lot of learning, analysis, research, due diligence, writing and decision making. If you consider any of the above as hard work, investing also demands equal attention and work. It makes it all the more better if you actually enjoy it.

    Entrepreneurs, Workers and Investors

    We love entrepreneurial stories and successes. We love to hear success stories and everyone aspires to be rich. Let us take a tech entrepreneur. For the most part, the founder is going to develop on his own or with a team. Society traditionally attributes hard work with workers, creators, or producers. You produced grains, software, music, etc. Along those lines, investors don’t produce but invest in producers. And hence it becomes a comparison of the hard work of an entrepreneur vs. worker vs. an investor.

    For an investor, where is the hard work? The hard work is in keeping up to date on the markets, trends, finding deals, researching deals, doing due diligence, and talking to various stakeholders (legal, etc.) throughout the process. If you look at 20 real estate deals, you may be lucky if you proceed with one. Many hours need to be spent on research and following trends for one investing idea. You will have nothing to show for, say, 9 of 10 investing ideas. Even the one that you have invested in may not work out as planned.

    Even long-term investors (similar to writers etc.) sometimes may feel that they have wasted time pursuing all those opportunities. Many times our thesis may prove wrong and in those cases, it is a double whammy. You’ve lost both time and capital. That is a hard feeling.

    Investing as a habit and mindset

    Investors cannot change what others think of active or passive investors. Not everyone is going to become Warren Buffet. We don’t think anyone should care what others think of their profession or them. Be true to yourself, you know the hard work that you put in to get that one out of ten deals that returns 2x. Don’t be hard on yourself, especially during trying times.

    Here’s the habit of Warren Buffett, one of the prolific investors. Here’s his habit even after he’s worth $80B or more. Luck plays a role, but can anyone argue against his habits and investing methods that made him the investor he is today?

    Once he’s in the office, he hits the books. CNBC reported that Buffett estimates he spends 80 percent of his day reading. He recommends that people try to read at least 500 pages a day.

    Source: https://www.afr.com/work-and-careers/management/inside-warren-buffetts-daily-work-routine-from-645am-to-1045pm-20170906-gybn7t

    In addition to forming an investing habit, our mindset plays a critical role. If our mind is not into the job at hand, then it is hard for us to become an expert. We may have some doubts initially, but even after some time if we don’t get over our negative associations with investing, it is hard to excel in that field. It is hard to reach the destination when we are swimming against the tide (our mind).

    Talking about mindset, it is important to talk about an investor’s emotions and how an investor needs to be objective. An investor is simply put, a capital allocator i.e. you put money behind businesses or activities that give the most return on the capital. But, investing is also behavioral i.e. you’ve to fight your own emotions when investing. Emotions make you thrive in a sport or art. It is actually the opposite in investing. Don’t get attached to your investments. You can be passionate about investing, but you cannot be passionate about your investments.

    Takeaways

    Hope this article provides encouragement to many on the journey as investors. It is a journey, it is not “easy” work and people have to develop good investing habits. In addition to developing good investing habits, investors also need to check in their emotions and make behavioral changes. As investors face the quandary of not becoming attached to their investments. If it doesn’t make business sense, be ready to part with an investment at a loss or sell when the entire market is extremely bullish. If you’ve aspirations to become a good investor, start immediately and spend some time every day learning, investing, and building good habits!

  • Does Preferred Return matter?

    Commercial Real Estate (CRE) Investor Question #83: What is Preferred Return and does it matter?

    Preferred return is part of a distribution waterfall in real estate private equity. We’ve seen earlier that a Distribution Waterfall refers to the way in which profits are allocated between the participants – sponsors and Limited Partners – in an investment.

    Preferred return is a key component of the distribution waterfall and its main purpose is to align incentives between the sponsor and limited partners(LPs). Let us take an example from EquityMultiple, a popular funding website:

    In this arrangement, the investor will receive a preferred return before any capital is returned to the sponsor; the investor will receive profits up to a predefined percentage rate of return. Let’s look at our Bushwick Mixed-Use Redevelopment Project. The order of profit distribution is as follows:

    1) 100% pro rata to investors (including the Sponsor and LPs) until they have received a cumulative 10% preferred return

    2) Return of investor capital contributions, pro rata

    3) 30% to the sponsor and 70% to investors (including the Sponsor, such that the Sponsor receives a share of the 70% in addition to their 30%)

    Source: https://www.equitymultiple.com/blog/commercial-real-estate-practice/preferred-return

    Preferred return aligns the sponsor to the LPs i.e. the sponsors won’t get any extra profit until a certain threshold is met. In the above example, both sponsors and LPs will equally share the profits until 10%. After that sponsors, will take an extra percentage of the profits (also called promote) which can be an incentive for them to perform better. For LPs, preferred return is always better than no preferred return for a given a deal, all other parameters being the same.

  • Holding Period Returns by Property Type?

    Commercial Real Estate (CRE) Investor Question #82: Can you compare Holding Period Returns by Property Type?

    National Multifamily Housing Council (NMHC) has done a comprehensive study on the holding period returns of key property types. The primary data source for this research is the MSA-level NPI data which includes quarterly property income and appreciation returns for the period 1978-2Q 2017. The NPI is a total return index of privately held commercial real estate properties owned by tax-exempt institutional investors. NPI returns are reported on an unlevered basis.

    Summary is as follows, again the returns are based on an unlevered basis:

  • High IRR, but low distributions?

    Commercial Real Estate (CRE) Investor Question #81: I invested in a CRE deal with a 15% IRR over 5 years, but I am only getting 7% annual returns in the first couple of years. What gives?

    IRR is based on all the cash flows during the duration of the deal i.e. 5 years in this case. Whereas, cash on cash returns are based on monthly or quarterly cash flows and the distribution check is sent to you.

    IRR includes income from operations AND capital events (refinancing or sale). Cash on Cash primarily consists of operational cash flow, absent any capital events. During the first couple of years there will likely be income only from operations and hence the 7% annual returns. You can expect a bigger distribution during the capital events.

  • Passive Income Puzzle

    Commercial Real Estate (CRE) Investor Question #80: Mary has saved $100k for her first real estate investment. Her aim is to add a passive source of income, in addition to her corporate salary. She is considering an equity investment in a syndicated multi-family deal that produces 7% Cash on Cash in Year 1. How much monthly income can she expect in Year 1?

    We’ve seen in earlier posts that Cash-on-Cash return indicates the percentage of your investment you’ll get back, on an annual basis. It is the before-tax cash flow (i.e. Cash Flow after Financing) of an investment in a given period divided by the equity invested as of the end of that period.

    • Equity Invested = $100,000
    • Cash-on-Cash Return = 7%
    • Annual Income = 7% x $100,000 = $7,000
    • Monthly Income = $7,000/12 = $583

    Mary can expect $583 monthly if the deal is executed as planned.

  • Investor’s long-term decisions?

    Commercial Real Estate (CRE) Investor Question #79: What are the key long-term decisions facing an investor?

    Here are the key long-term decisions facing an investor. This will form the investor’s long-term investing approach or strategy:

    • What is the investor’s overall investment thesis/strategy?
    • What is the investor’s portfolio strategy for Real Estate?
    • What property type(s) and markets to focus on?
    • What size (# units) and price to focus on?
    • How many deals to do and the returns expected?
    • Who to invest with for the deals and the investor’s role?

  • Top 10 issues facing CRE?

    Commercial Real Estate (CRE) Investor Question #78: What are the top 10 issues facing Commercial Real Estate?

    The Counselors, a commercial trade group for CRE designees, surveyed its members to identify current and emerging trends in the commercial sector for its annual list of issues affecting real estate for 2020–2021:

    1. COVID-19
    2. Economic Renewal
    3. Capital Market Risk
    4. Public and Private Indebtedness
    5. Affordable Housing
    6. Flow of People
    7. Space Utilization
    8. Technology and Workflow
    9. Infrastructure
    10. Environment, Social, and Governance

    The full article can be found at https://magazine.realtor/daily-news/2020/06/30/top-10-issues-facing-commercial-real-estate