Preferred Equity. The Right Strategy

Is now a bad time to get involved in some investment? JP Morgan Chase CEO, Jamie Dimon said, “We are still having geopolitical conflict happening; the Ukraine war is causing different problems in food, gas and energy prices globally and inflation remains rampant, we have uncertainty over high interest rates that might happen. Combine that with a waning consumer confidence, we are heading to some really rough times.” Naturally, investors are looking for much more safe investments where their money can grow and hopefully not experience losses.  

Prefer equity is a unique strategy that is typically available to those in the institutional world. It is a combination of debt and equity. What does this mean to an investor? This means this is a type of investment that has 75% on the return of being an actual equity investor but it decreases the risk by over one third. This is very compelling to a lot of investors, especially high-net-worth individuals that have a lot of capital and a goal to not lose their money but instead to gain from it. If you are this type of investor, preferred equity might be the correct path of investment for you. Additionally, preferred equity is much lower investment than common equity. Why? Because it provides favorable risk adjusted return especially during times of economic crisis and this is very valuable in today’s uncertain economic development due to the pandemic and war that is currently happening. 

Before jumping to the conclusion that preferred equity is a must to do investment right now, Let’s look at also what common equity is.

Let’s say we bought a $1 million building, called the capital stack, and we borrowed $700,000 from the bank, called debt. You might wonder, where did the $300,000 go? The $300,000 for this investment will come from what we call equity or common equity. Common equity is what the investors want to invest.  In this example, an investor puts $300,000 of capital down, becoming the equity.  The $700,000 is the amount borrowed from the bank.   We used the combined amount of money to buy this $1 million building, this is called capital stack.  If we sell the property for $1.1 million, the first thing that gets paid is the debt. We have to pay off the debt which is $700,000 and the remaining $400,000 money will go to pay off the equity investor to get their $300,000 back.  The remaining  $100,000 will be our profit. In terms of safety, the person on the debt side gets the money first which puts them in the safest position and the rest in the less secure position.   

Using the same example where we bought a $1 million property, but we sold it for $800,000. Who in the capital stack will take the loss? Well, we got the $800,000 sale where the first thing that happens is $700,000 goes to debt and the remaining $100,000 would go to common equity. The first person loss position in this example is the common equity because if there’s loss on the sale of a property, the one that would feel the loss is the person closest to the top. In this same situation, where does preferred equity take place? Still a $1 million property but the capital stack would take $700,000 as debt, we’re borrowing $700,000 of that $1 million from the bank, but then we insert a preferred equity of $100,000 in between the common equity, which is $200k. And instead of $300k of common equity like we had in the previous example, we’re taking $100,000 of preferred equity and $200,000 of common equity. 

There is a buffer between the common equity and debt and that’s where preferred equity can be found. Somebody that’s sitting in this position, especially during times of uncertainty, they are in a better position because they’re more likely to get paid than common equity. As they get paid first, they also get back their money plus investment so that they can be in a better position than the common equity. Due to their money going out first in paying debts, they would first pay the lender and second is the preferred equity investor. They must return all of their capital plus their preferred return which is a set percentage and the remaining money left goes to the common equity investor.  The benefit to the preferred equity investor here is that they have a significant protection on the downside, right? Because they’re going to get paid preferentially over common stock investors.

In this situation, why would anybody want to be a common equity investor? There are pros and cons of being in a preferred equity investment. A preferred equity investor may only get a set amount of return, an example of 9%, in addition to their money back. and say.  Meaning if a preferred equity investor invested $100,000 then they’re going to get 9% per year. They’re going to make $9,000 per year for the duration of that investment, which in a syndication could be anywhere between three to seven years. As there are pros, there are also cons.  

The preferred equity investor is also capped.  If their profits are at 8% they’re only going to get 8% return instead of 18%. Extra profits, 10%, that they could’ve seen as a common equity investor, they’re not getting it as a preferred equity investor.  That extra money goes up into this common equity. The trade off here is higher risk, higher rates of returns and vice versa.

It will all depend on where you are in your risk spectrum, and how much you are willing to accept. On preferred equity, you can get 75% of the returns compared to a common stock equity investor who only got one third of the risk and that risk is important. 

Where are you at your stage of career? Where are you in your stage of investing? Where are you in your risk tolerance?

For some, when there’s all this economic uncertainty and it’s just too much turmoil going on, preferred equity may make sense and might be a good option. It’s going to hedge you against inflation, you’re still going to get excellent positive returns, and a much lower risk position and for others where they strongly believe in this deal and would say “ Hey, we’re getting this deal at a steal, at a great cost basis so that the profits are essentially built-in, I’m willing to take on that risk because I believe so much in this project and I’m willing to get a much higher upside because of it.” Whatever they may choose between being a common equity investor or a preferred equity investor is a personal decision and this decision should not be taken lightly and if you need help making that decision, turn towards your trusted advisors, and they may be able to shed some light onto which route to go.