Preferred Equity: Better Risk-Adjusted-Returns Are Perfect For Uncertain Times – Steven Pesavento Transcription:
Steven Pesavento 00:00
Welcome back to the Investor Mindset podcast. I'm your host Steven Pesavento. Each week we share mindset tips and real estate investing strategies to help you take your business and your portfolio to the next level. Today, I am grateful to be able to bring to you a phenomenal topic that we think is perfectly positioned for this time in the market. It's called preferred equity. It's a unique strategy that is typically only available to those in the institutional world or in opportunities where you're investing with a much lower return percentage, we're going to talk about the different types of preferred equity, what that looks like, what the benefit is, when it makes sense to invest in preferred equity and why and when it makes sense to focus on common equity. So we're gonna get to that and more in this episode, so you're gonna want to stay tuned.
Steven Pesavento 00:54
This is the Investor Mindset podcast and I'm Steven Pesavento. For as long as I can remember, I've been obsessed with understanding how we can think better, how we can be better, and how we can do better. And each episode we explore lessons on motivation and mindset for the most successful real estate investors and entrepreneurs in the nation.
Steven Pesavento 01:13
If you're interested in getting involved investing the same type of real estate investment opportunities that I personally invest my own capital into, then head over to VonFinch.com/invest, to be able to register for a private capital network, where you can apply to invest alongside many other successful like minded people just like you and be able to take advantage of some of these phenomenal opportunities, including preferred equity. So let's get to it. All right. So preferred equity is a unique hybrid investment strategy that is a mix between debt and equity that provides downside protection, while providing a preferred return to investors. preferred equity investors typically receive a return of capital, while also receiving a return on capital prior to any other equity investors in that opportunity being paid any cash flow. What's the benefit of that that means that those common equity investors are in a first loss position. And that creates a buffer for preferred equity investors during times of uncertainty. In exchange for giving up a little bit of the upside, we're able to obtain a significant downside protection set differently preferred equity investors in today's market with the structure that we're going to be talking about today that VonFinch has put together, is able to achieve about 75% of the return, while only taking about a third of the risk. We're going to talk about how that works and how we come to that understanding in just a second. But first, it's important to understand that preferred equity is a much lower risk investment compared to common equity, that it creates attractive risk adjusted returns, which is very valuable in today's uncertain environment. And that there is a huge benefit when you're investing into preferred equity fund, because that fund itself can then go out and negotiate much more favorable terms for the fund because in exchange, it's offering a higher level of certainty of close. And it's a neutral third party who's going out and making that negotiation with those individual operators. So it's important, of course, to have an extremely experienced team who is underwriting and vetting and doing due diligence on those individual deals, because those individual investments act like individual loans very similar to the underwriting that's going to go into placing a $50 million loan when placing a five or a $15 million preferred equity check. Those pieces all have to be executed. And the risk profile of different deals needs to be taken into account when creating those term sheets.
Steven Pesavento 01:23
So in that scenario, you can see that, you know, typically, when you're investing as equity, you're getting all the upside above the debt. And that's a phenomenal place to be. However, the alternative in Scenario two would actually be that same 35% debt coming into play, while an additional $5 million of preferred equity comes into play, creating a total loan to value of 80%. That extra $5 million. preferred equity means that total loan to value is is 80%. And what that really means for preferred equity investors is that there's 20% of common equity 20% of someone else's money other than your own, that's sitting above that preferred equity, those common equity investors receive a higher rate of return, in exchange for that higher rate of return, they receive higher risk, right, so that means that the property could lose $10 million of value, ie 20% of its value, before preferred equity investors would have any type of loss that's really valuable. In today's market where we're seeing higher interest rates, cap rates are starting to slowly raise we're seeing loan devalues being reduced greatly. And that creates an opportunity to come in and be able to be in a more secure position in the capital stack.
Steven Pesavento 04:18
So let's look at a quick example to really illustrate the difference of preferred equity. So let's talk about scenario one. Right, the traditional common equity this is you know, von finches purchase over 200 properties, primarily, those 200 properties where we were placing debt, while we were also putting our own equity onto those properties. And we were creating a return and then the other 10 or so as of right now and 2022 large multifamily deals that VonFinch has purchased. We've invested all as common equity. So what common equity really is is it's the chunk of equity that sits above debt. So with a $50 million property, a lender who's going to lend up to 70%, would put down $35 million of the, of the cash that's actually needed to purchase that $50 million property. So the common equity is that additional $15 million of equity that is needed in order for that individual investment to be purchased.
Steven Pesavento 07:00
As Blackstone recently said, it's the first time in over a decade that it's made sense to focus on preservation of capital over exclusively focused on upside, appreciation. Really important to underline that again, the first time in over a decade, Blackstone says that it makes sense to focus on preservation of capital. So let's go into this a little bit deeper, what that actually looks like. So when you're thinking about an investment, you want to think about what's the risk versus the reward. And the reason why we can create a scenario where we're taking significantly less risk, but we're able to create approximately the same type of return is because of that position and the capital stack and the ability to negotiate for a better return. Why is this valuable to operators and sponsors? And why would an extremely experienced operator be interested in doing a joint venture with a preferred equity fund like von finches preferred equity fund? Well, the reason is that in today's day and age, in today's market, we're seeing that returns are being compressed. So what does that mean? That means that last year when we were purchasing properties, and we were offering a 17% IRR, we were going to go in and renovate that property, we're going to reposition it, potentially refinance it or sell it, and then hold that property for cash flow. So in that scenario, we were getting debt at about 70 to 75% loan to value meaning we only needed to bring about 3025 or 30% of equity. And we were seeing interest rates in the three and a half to 4% range. Now in today's market as of August 2022. We're seeing interest rates in that four to six potentially even higher rate while also seeing loan to values being reduced as low as 50 or even 60%. So what that means is now operators are being required to bring 50% or 40% of the equity. And what that means for investors is that the rate of return is going to be reduced. What was a 17% return last year, that same deal with the same risk profile purchase today with today's debt at a higher interest rate is now going to most likely be in that 14 to 15% or below range. So because you're paying more to the bank and interest and because the returns are being split between more dollars and equity, that return ratio is going to go down. And so that actually creates a really valuable place for preferred equity to come in. Because if that debt is coming in in that four to 8% range at 60%. And the common equity has been reduced in a return rate down to, like we're talking about maybe even 10 to 1410 to 15%. Those operators are interested in bringing more equity to the table with having a higher level of certainty of clothes while reducing the rate. So if we can go into a scenario where we can offer investors 11% preferred return, that means we must go place that preferred return at maybe 12%. VonFinch makes a percent, investors make 11%. And then the operator is saving, maybe two, maybe 3%, that they're then able to spread that around to their investors, making it a true Win Win, which is why we're able to attract some very high level sophisticated experienced operators, while also being able to back some great up and coming operators who have phenomenal teams with experience in that market and who have cycled through multiple deals, but is in a position where they really could use that consistency of a capital partner, like a preferred equity fund like VonFinch to be able to fill that space. And so can you start to see how we can create about 75% of the return 11% versus 14, about 75% of the return, while only taking about a third of the risk, because we're before in that lower risk position. And 20% loss can happen before VonFinch is impacted. While the risk profile dramatically being reduced as you go deeper into the capital stack, it's not just a a divided out type of equation, there is a standard deviation that actually happens, the higher up in the capital stack. So we're, we're able to get to that about a third or so of the risk profile.
Steven Pesavento 12:00
So why is this important for you? And how does this start to fit into your portfolio? Well, the way that it fits in your portfolio is you want to start thinking to yourself, well, what am I looking for right now, and what's important to me, maybe what you've purchased over the last few years have been types of assets that are focused on heavily on growth, maybe you have a lot of assets that are focused on growth. And what you're looking for today is creating some current cash flow, maybe you're looking to create a four to 6% cash flow in today's environment. Again, as interest rates have gone up and loan devalues have gone down. Cash flow that was projected last year at 8% might be as low as 4% this year. So huge difference. And so it's important to understand that as an investor, but it's also important to then go and look for opportunities that have a good risk adjusted return to get that same place it from a cash flow perspective. So how this fits, then is looking at your portfolio and saying, I'm potentially looking for some type of consistency of return, I want to hedge against inflation. I want to create income today, I want to know that I have a much, much higher likelihood of hitting that income number in the future. And knowing that while we're in times of uncertainty, I can greatly reduce my risk. So what we're seeing for most investors and the appeal that we've noticed on the on why investors are so interested in being in that preferred position really comes down to knowing that they have a huge buffer that will protect them should something go wrong. Now when we look back to the worst recession that we've seen, in our lifetime, back in 2008, real estate prices went as low as 30 or 40%. In many markets, right? They reduced that greatly. And that was a huge real estate led recession. We're in a current time and market where the economy overall is performing quite well. Right. The real problem that we're dealing with today is that we've pumped a lot of money in and we're seeing inflation. So the Fed is trying to tamper that down by raising interest rates and trying to slow down the growth that's happening, and they're doing an effective job. It may take six months, it may take two years, we don't know exactly what that'll be. So we can't really sit and wait on the sideline because inflation is still negatively impacting our cash in the bank. So we want to be looking for opportunities where we can truly hedge against inflation. And so the reason why we like this strategy is because it really does hedge against inflation nicely. It allows us to be in a lower risk position. And you know, as we've talked about before, we brought on our chief investment officer Mark Gallin arrow We specifically sought out an institutional Lee trained investment professional, who had a strong understanding of some of the fundamentals that go into the selection process for institutional style operators. Because in the institutional world, the way that it works is, these big funds will have hundreds of millions of dollars. And they'll go find individual operators. And they'll set up a joint venture where that investment fund has near 100% control over the key decisions of what's happening at that property. So they can manage and asset manage, and really lead and drive what's happening and those operators are actually executing on behalf of that fund, while they receive their profit really comes down to bait being based on success.
Steven Pesavento 15:52
Now, that's a similar in the syndication space. But what we have been able to put together here is take some of the advantages for investors from that space, and now go and serve that middle market. And the reason there's such a big need for this is most of the preferred equity providers in the market, they are folks who have raised $100 million, they're getting large checks from large pension funds. And from an administrative perspective, it doesn't make as much sense to write a three or $5 million check, they want to write a 10 or $20 million check. And so what we found is that there might be a very large number, an example of comparison, there might be three providers in the middle market, and there might be 25 or 30 providers in the larger than five or larger than $10 million market. Yet, there's so many operators who are buying middle market deals deals that are in that 20 to 50 million million dollar purchase range that we're able to then go in create a win win partnership with while also being able to get a higher rate of return, because you'll notice, something we've we have yet to talk about is that typically preferred equity is only receiving, you know, a six to 8% return, you know, sometimes it can be as high as 10, or 12%. And because of that focus in the structure, we're able to create that higher preferred return while still being in a much lower risk position. And so from an execution standpoint, we've we already have some great operators that have been gone through due diligence from our existing relationships, we've got deals coming in every day from debt and equity brokers that are looking for this, this equity. And they have great clients that are very reputable. And we've got the due diligence teams, both from a legal as well as an internal perspective that we'll be able to review all of the details to make those individual selections. And that will be led up by myself, as well as Mark Allen era or chief investment officer, who again, worked at one of the largest real estate funds executing strategies exactly like this, but with much larger check sizes. So we're able to bring that experience to the table. And just as we've done with our other 10 common equity yields, which hold a higher risk profile, we're able to be in a much lower risk position and execute that for investors.
Steven Pesavento 18:17
So I really believe in preferred equity, I highly recommend that you add it to a place within your portfolio and you find a team that you know, like and trust and you believe in that you can play some some equity in that type of structure. In this market today, as we see fluctuations, it really makes a lot of sense. There's a really, really strong thesis out there. And it's one that we're excited to continue to execute on and be able to provide some great returns for investors, some great capital for operators and our partners, as well as being able to have cash available when we find that phenomenal deal that that we know investors are really looking for. So we're going to bring all of our experience to the table to execute on this one. If you're interested in finding more you can go to VonFinch.com/pref, that's VonFinch.com/p, R E F, to be able to register to learn more about this preferred equity offering to check out any kind of investment materials. Of course, this offerings only available to accredited investors. But if you're not accredited, no problem, head over to VonFinch.com/invest Get registered and we look to do maybe one or two deals a year that are available to non accredited investors so that our friends and family can be able to invest alongside us and we can all create that freedom, flexibility and fun that we're really after. So thanks for joining me today. Thanks for joining us. We look forward to working directly with you on this and many more investment opportunities in the future. We'll see on the next one
Steven Pesavento 20:00
And thank you for listening to the investor mindset podcast. If you liked what you heard, make sure to rate review, subscribe and share with a friend. Head over to the investor mindset.com to join the insider Club, where we share tools and strategies from the top investors and entrepreneurs and how to take it to the next level.
