UNDERSTANDING PREFERRED EQUITY
What on Earth is Preferred Equity?
Explained in Simple, Layman’s Terms
Get excited. Preferred equity makes closing commercial real estate deals
much easier.
If you are a buyer of commercial investment real estate – like multi-tenant
office buildings and strip centers – preferred equity allows you to buy the
property with a much smaller down payment. Commercial brokers, you
should be doing dog-flips over the possibility of getting your commercial
real estate buyers into properties with just a 25% down payment.
If you are a banker, preferred equity allows you to close safe, new,
commercial real estate loans at just 58% to 63% loan-to-value, even though
your borrower is insisting on 75% financing.
And if you’re a commercial mortgage broker, imagine being able to compete
against Bank of America, Wells Fargo Bank, or JP Morgan Chase on a new,
$2 million, commercial permanent loan – and then winning! How could you
possibly win against these behemoths? Because you can often get the
borrower more leverage. You can lend up to 75% loan-to-value, or maybe
even 80% LTV, when these big banks are limiting their deals to a much
lower LTV. In many cases, it’s not the lender with the lowest interest rate
that wins. The winning lender is often the one willing to loan the most
money.
“That all sounds great, Lloyd, 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 stack 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.”
This is a Lloyd Carrington Jr. speaking 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. i may take a $400,000
preferred equity position in your building to make up the shortfall.
I.F.G.Inc.is 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.
Do you have a potential deal? Please call Lloyd Carrington Jr. at 972-891-9364
or email lloyd@interstatefinancialgrouponline.com. In the Subject line, please type,
“Preferred Equity Deal.”
http//::interstatefinancialgrouponline.com
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