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Understanding and Evaluating Preferred Equity Investments

In today’s fluctuating market, with frequent mentions of a potential recession, finding
investments that can outpace inflation and safeguard your hard-earned cash is crucial. One
effective strategy is incorporating preferred equity into your portfolio. Preferred equity
offers stable, predictable income with less volatility than common stocks and potentially
better returns than money market accounts. Backed by a hard asset in real estate, it serves
as a balanced addition to a diversified portfolio, blending income generation with risk
management.

Preferred equity involves an investor supplying capital to a project in exchange for an
ownership stake with preferential status. Investors receive a preferred return on their
investment before any distributions are made to common equity holders but after the senior
and mezzanine debt obligations are met. This predictability and payment priority make
preferred equity a safer choice, appealing to conservative investors or those looking to
balance their portfolio with less risky investments. It is important to note that returns are not
guaranteed if the project fails, so perform your due diligence on your sponsor before
investing.

Understanding the Capital Stack

In order to understand preferred equity, it is important to understand the elements of the capital stack and thus risk exposure. Typically, the higher one’s position within the capital stack, the greater the risk assumed, but the higher the rewards in exchange for taking that risk. At the base of the stack lies the lender or senior debt, holding the lowest position due to their ability to foreclose on the property and recoup most losses through equity. Following this is the supplemental loan or mezzanine debt, typically associated with higher interest rates reflecting greater risk relative to senior debt. A preferred investment class occupies the subsequent position in the stack. Finally, common equity, which includes both investors and sponsor(s), who share equal risks and rewards.

The Capital Stack

Why Preferred Equity is the Better Investment Vehicle

Criteria Preferred Equity Stocks Money Market
Stability & Predictability of Payments Offers fixed, regular dividend payments, providing a steady income stream. Often less volatile than common stocks, offering more predictable returns. Can provide higher returns but are more volatile and subject to market fluctuations. Dividend payments are not guaranteed and can be cut or suspended. Offers safety and liquidity, but with much lower returns. Interest rates can be very low, especially in a low-rate environment. Suitable for short-term savings but not ideal for significant growth.
Income Generation Designed to generate income through regular, often higher, dividend payments. Attractive for income-focused investors, such as retirees. Potential for income through dividends, but the primary focus is often on capital appreciation. Dividend yields may be lower and less consistent. Provides some interest income, but generally lower than preferred equity dividends. More suitable for parking cash temporarily rather than generating substantial income.
Risk & Volatility Lower volatility compared to common stocks. Less exposed to market swings, offering more stability. Seniority in the capital structure provides a cushion. Higher potential for capital gains but also higher risk and volatility. Subject to market trends, economic cycles, and company performance. Very low risk and high liquidity. Minimal returns due to low-risk nature.
Diversification Adds diversification to an investment portfolio. Offers a middle ground between the risk of common stocks and the stability of bonds. Essential for growth but can be risky if not diversified across sectors and geographies. Safe but not very diversified in terms of returns and growth potential.

 

Preferred Equity Real Estate Asset Classes

Generally, asset classes with higher potential returns also carry higher risks.

Asset Class

Pros

Cons

Risk Factor

Ground-Up Development

  • Potential for high returns once the project is completed.
  • Customization to meet current market demands.
  • Potential for significant value appreciation.
  • High construction and development costs.
  • Regulatory and zoning challenges.
  • Longer timelines before generating income.
  • Market conditions can change during development.

High

Hospitality

  • High revenue potential during peak periods.
  • Opportunities for brand affiliation and loyalty programs.
  • Flexibility in adjusting room rates based on demand.
  • Highly sensitive to economic cycles and travel trends.
  • Operational complexities and high fixed costs.
  • Seasonality and competition impact revenue.

High

Office

  • Long-term leases providing stable income.
  • Opportunities for redevelopment and repurposing.
  • High-quality tenants and potential for rent escalation.
  • Changing work habits (e.g., remote work) reducing demand.
  • High tenant improvement costs and long lease negotiations.
  • Market saturation in certain urban areas.

Moderate

Retail

  • Prime locations can attract high foot traffic.
  • Mixed-use developments can enhance value.
  • Opportunities for experiential retail concepts.
  • Decline in brick-and-mortar shopping due to e-commerce.
  • High tenant turnover and vacancy rates.
  • Significant impact from economic downturns.

Moderate

Student Housing

  • Consistent demand in college towns.
  • Lease terms aligning with academic calendars.
  • Opportunities for premium rents in high-demand areas.
  • Seasonal occupancy with high turnover rates.
  • Dependence on university enrollment trends.
  • Potential for property damage and higher maintenance costs.

Moderate

Multifamily

  • Steady demand due to the necessity of housing.
  • Economies of scale with multiple units.
  • Opportunities for value-add improvements and rent increases.
  • Economic downturns can affect occupancy rates.
  • High competition in popular areas.
  • Rent control regulations in certain markets.

Moderate

Single Family

  • Strong demand, especially in suburban areas.
  • Easier to finance and liquidate compared to multifamily properties.
  • Opportunities for appreciation in home values.
  • Higher management and maintenance costs per unit.
  • Economic downturns affecting tenants’ ability to pay rent.
  • Potential for property vacancies.

Moderate

Industrial

  • Strong demand due to e-commerce and supply chain needs.
  • Long-term leases with stable tenants.
  • Lower maintenance costs compared to other property types.
  • Location dependency, as proximity to transportation hubs is crucial.
  • Market saturation in certain areas.
  • Economic downturns affecting demand for storage and manufacturing space.

Moderate

Self Storage

  • Steady demand due to life events and business needs.
  • Low operational costs and management requirements.
  • Flexibility in adjusting rental rates
  • Market saturation in certain areas.
  • Economic downturns affecting occupancy rates.
  • Potential for property damage and security issues.

Moderate

Mobile Parks

  • High demand for affordable housing.
  • Stable, long-term tenants with low turnover rates.
  • Lower capital expenditures compared to other asset classes.
  • Zoning restrictions and regulatory challenges.
  • Potential for negative stigma affecting demand.
  • Management and maintenance complexities.

Moderate

Choosing the Right Preferred Equity Investment

  1. Assess Your Risk Tolerance

    Begin by honestly evaluating your risk tolerance. Are you a conservative investor seeking stable, predictable returns, or are you more aggressive, willing to accept higher risk for the possibility of higher returns?

  2. Perform Due DiligenceConduct thorough due diligence on the sponsor or operator. Review their track record, past performance, and experience in managing similar investments. Look for transparency, communication practices, and alignment of interests between the sponsor and investors.
  3. Consider the Investment Structure

    Look into the specific terms and structure of the preferred equity investment. Key aspects to consider include: Payment Priority: Preferred equity holders typically receive distributions before common equity holders. This priority can provide a layer of security in receiving returns. Accumulation Feature: If the preferred return is not paid in a specific period, does it accumulate and get paid out in the future? Accumulation can protect your returns over the long term. Redemption Rights: Understand the conditions under which you can redeem your investment. Some preferred equity structures may have specific lock-in periods or penalties for early redemption.

    Download our Preferred Equity Investment Evaluation Tool to evaluate your next opportunity!

    BODC Preferred Income Fund

    The BODC Preferred Income Fund sets itself apart by offering a swift liquidation process, requiring only 45 days’ notice compared to the 60-90+ days customary in traditional funds. This strategic investment not only provides flexibility and stability for your portfolio but also yields an 8% return on your initial investment. Monthly distributions are backed by a hard asset and shielded by depreciation.  Learn more here!

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