The Passive Investing from Left Field podcast recently welcomed Paul Moore, Founder and Managing Partner of Wellings Capital, to discuss preferred equity investing. Paul is the author of several real estate investing books and a regular contributor to BiggerPockets. He explained how preferred equity works, its benefits over common equity, risks to be aware of, and how to evaluate deals with preferred equity.
Below are the quick hits and top takeaways from Paul’s insights:
Preferred Equity vs. Preferred Returns
It’s important not to confuse preferred equity with the preferred returns that General Partners (GP’s) provide to Limited Partners (LP’s). Preferred returns are a hurdle rate that ensure LP’s get paid before the GP. Preferred equity is very different – it sits between debt and equity in the capital stack. It carries lower risk than common equity but higher returns than debt.
How Preferred Equity Works
Preferred equity sits in the capital stack between senior debt and common equity. For example, a deal may have 60% senior debt, 15% preferred equity, and 25% common equity. Preferred Equity acts like debt in that it receives steady cash flow payments, but has upside like equity. This “best of both worlds” approach can produce returns around 14-18% today. Learn more about capital stacks.
Upside for Investors
For operators, preferred equity can provide value-add capital to execute their business plans and allow them to take profits earlier via refinancing or buying out preferred investors. For preferred equity investors, it provides debt-like cash flow with equity-like upside. The downside for common equity holders is preferred equity holders reduce their upside.
Risks to Common Equity
Existing common equity investors face dilution and reduced upside. Their equity gets pushed further down the capital stack. And if things go poorly, they will feel pain before preferred equity holders. It’s key for LP’s to read the PPM and operating agreement to understand if preferred equity could be included in the deal. Learn more about LP risks.
Evaluating Deals with Preferred Equity
Do thorough due diligence on the operator’s track record and experience with preferred equity deals. Make sure to always…
- Understand the business plan and risks like reliance on debt.
- Read the PPM carefully and get a third party legal review if needed.
- Verify your understanding of preferred equity terms directly with the operator.
Investing in Preferred Equity as an LP
Individual LP’s generally can’t access preferred equity deals on their own. Options include preferred equity funds, sidecar deals with existing GP sponsors, or pooling capital into a large preferred equity investment. Overall, preferred equity remains a fairly uncommon, niche investment opportunity.
Paul Moore offered excellent insights into preferred equity investing on the Passive Investing from Left Field podcast. Be sure to give the full episode a listen here and check out the other podcast episodes we did with him, Buying Income Streams by Investing in Mobile Home Parks and Self-Storage with Paul Moore and Creating Wealth with Cash Flowing Assets with Paul Moore.
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