If you are a buyer of commercial investment real estate – like multi-tenant office buildings and strip centers, multi-family or other commercial properties – preferred equity allows you to buy the property with a much larger down payment.
“That all sounds great, Bill, but what on earth is preferred equity?”
The best way to understand preferred equity is to listen in on a conversation between Bob Young, a 40-year-old owner of a successful tool and die company, and Steve Elder, his father-in-law, a 65-year-old retired real estate broker.
The younger man wants to buy a $1.5 million strip center in a suburb of Austin, Texas. He applied to the bank for $1,125,000 loan, which is 75% of the purchase price. His plan was to put down $375,000 in cash, which is 25% of the purchase price. Bob is pretty excited about this deal because there was been very little new commercial construction going on in Austin for the past six years, during which time the population has swollen by another 65,000 residents.
Unfortunately, the bank came back and said, “I’m sorry, Bob. We like the project, and your credit is impeccable, but Loan Committee is still pretty nervous about the economy. The most we’ll lend is $1 million. You’ll have to come up with an extra $125,000 in down payment.” The problem is that Bob doesn’t have an extra $125,000 in cash to put down – hence his visit to his father-in-law.
After hearing about the fundamentals of the purchase, Steve Elder says, “The deal sounds fine, Bob. I have the dough to invest, but at this stage of my life, I’m looking for immediate income, not the chance to double or triple my investment over the next five years. Why don’t I just loan you the $125,000 and take a second mortgage on the property?”
[Important note!] “Unfortunately, Mr. Elder,” Bob replied, “banks won’t allow second mortgages on commercial properties anymore. After the Great Recession, they are worried about overburdening the property with debt. If money gets tight, the owner might be tempted to use the monies earmarked for repairs and maintenance to make the payments on the second mortgage. The repairs would go unmade, the property would physically deteriorate, the roof might start to leak, the tenants might start to move out, and the bank might end up foreclosing on a vacant building infested with mold.”
“Bottom line, Mr. Elder,” Bob concluded, “banks simply will not allow second mortgages on commercial properties anymore.”
“You know, Bob,” says the old-time real estate broker. “you’re a good businessman, and you have been a great husband to my daughter. I’m going to help you. Here’s how we’ll structure the deal.”
“I’ll go in with you to buy this property. I’ll contribute $125,000 in equity, and we’ll add my equity dollars to your $375,000 down payment to raise the $500,000 down payment required by the bank. The bank will make its $1 million first mortgage, and there will be no other debt on the property.”“You and I, Bob, will form a limited liability company, and we’ll put in the Operating Agreement a customized agreement on how we’ll split the cash flow and the profit. After all, you’re still a young buck, and you won’t be ready to retire for another 25 years. The most important thing to you, since you’re still getting a monthly paycheck, is the chance to double or triple your money.”
“In contrast, I’m 65-years-old, and I’m retired. I need monthly income. Therefore, I’ll trade you. I’ll give you all of the upside profit, after I get a preferred return of, say, 16% annually. You can have the rest of the profit. My investment is what is called a “preferred equity investment.”
“Will the bank allow this? Your investment is sort of like a second mortgage.” the younger man asked.
“Sure, the bank will allow it,” replied the old veteran. “Unlike a mortgage, the monthly payments on a preferred equity investment do NOT have to be paid. If the cash flow on the property is tight, the owner can simply allow the preferred equity payments to accrue and defer. Of course, the unpaid preferred equity payments compound monthly at a 16% annual rate, so you probably would not want to miss too many payments. The preferred return would quickly eat up the owner’s equity.”
“Mr. Elder,” Bob commented, “I greatly appreciate your help, but why does your preferred return have to be so HIGH? 16%? Ouch!”
“Bob, this deal has to make sense for both of us. I could take my $125,000 and invest in hard money first mortgages yielding 12%. This would be far less risky.”
“Just think about it,” Mr. Elder continued. “If you lost your commercial tenants, I might be forced to make the $6,300 monthly payments on the first mortgage every month for God knows how long, until we find new tenants; otherwise, the bank would simply foreclose and wipe us out.”
“I couldn’t even sue you to collect my $125,000 investment because I’m an equity investor, rather than a lender. You will never even sign a note promising to repay me,” Mr. Elder explained. “My investment is equity, not debt. My repayment is totally dependent on the success of this venture. Yields of 16% to 22% are quite common for equity money.”
“But Mr. Elder,” Bob complained, “how can I make any money when I have to pay 16% for capital?”
“There is an old saying in finance, Bob,” the wise veteran counseled. “The Lord forgives everyone except he who fails to crunch the numbers. You need to do the math. Sure, you’ll be paying 16% on $125,000 – but because of our combined down payment, you will get to borrow $1 million at just 4.875% interest! Your weighted average cost of funds on your $1,125,000 total capital stock is just 6.1%. By historical standards, that’s incredibly low, even lower than the cap rate on this strip center. You’ll actually be earning a positive spread on your debt. In other words, you’ll enjoy a handsome positive cash flow.”
“But it gets better, Bob,” Mr. Elder joked, using his best imitation of a Ronco TV advertiser’s voice. “I’ll let you prepay me, in full or in part, at any time, without penalty. Therefore, if you have a good month, and the property throws off an extra $3,000 that month, you can send that $3,000 on to me and thereby reduce the amount upon which you are paying 16%.”
“Bob, this is a good deal for both of us. You should do it.”
Back to me now. You can use our preferred equity for more than just the purchase of commercial real estate. For example, let’s suppose you have a $2 million balloon payment coming due on your office building, but your bank will only lend you $1.6 million. We will arrange to take a $400,000 preferred equity position in your building to make up the shortfall.
We looking for preferred equity deals, between $100,000 and $600,000, nationwide. (We might consider up to $1 million in California or in one of the economically booming areas of Texas.) We do not invest in new construction or land deals, and our appetite for renovation deals is very limited. Renovations almost always cost twice what the developers project.
We greatly prefer garden-variety rental properties, such as apartment buildings, office buildings, shopping centers, strip centers, retail buildings, industrial buildings, and self-storage facilities. We do not like special use, single-purpose properties; but we might consider a newer, flagged hotel.