The ability to earn robust passive income with strong risk protections in place is attractive to most investors no matter where they put their money or what methods they use.
Preferred stock investments in commercial real estate transactions and funds are an underutilized, but potentially reliable way to achieve this result.
In fact, demand for preferred shares has increased recently as activity in the real estate market increases, competition intensifies, institutions creep into smaller deal sizes, and sponsors seek more yield – and a corresponding inflow of capital.
That said, there are few regular preferred stock providers for amounts ranging from $1 million to $5 million, leaving a large segment of option-seeking sponsors underserved.
This demand and lack of supply provides investors with a potentially attractive risk-adjusted return: an opportunity to access trades with upside potential, while structured with downside protection, through equities. privileged, if they know what they are looking for.
Let’s explore what advisors should know about low balance preferred stock investing.
What is Preferred Equity?
Preferred shares have always been a vague term that has evolved over time. Essentially, it is a senior investment in the capital stack after debt and protected from losses by investing in common stock. In other words, preferred stock investors receive current income, a share of the upside and downside protection through default-type covenants.
What does the small balance space offer investors?
Real estate activity is moving at a faster pace than ever in many markets across the country, especially as the pandemic has accelerated migration trends.
Many sponsors of small to medium deals around $5-40 million seek to bridge the gap between the first mortgage and traditional syndication methods, which historically relied on friends and family, a large LP, or crowdfunding. . Preferred shares appear to be a more accretive option to fill this gap.
There are only a few reliable preferred stock sources issuing checks for $1-5 million. That said, offerings in this size range–especially those in smaller suburban growth marketsimplementing value-added business plans – can still offer higher return potential than larger institutional real estate investments.
This short-term investment model allows investors to capitalize on current trends, rather than future market growth, resulting in immediate returns and less risk.
What should advisors look for?
Because the exact role preferred shares play in capital and investment structures can vary, advisors evaluating preferred share funds should look closely at fund managers’ strategies, how they structure their investments with the underlying sponsor and the types of sponsors they target to determine if there is an appropriate risk-adjusted return.
When identifying a preferred stock opportunity, five key factors to look for are:
- Current cash flow paid from operations or reserves;
- A preferred priority return;
- Share buybacks that are paid before all other equity investors;
- profit sharing (i.e. “equity kickers”); and
- Non-Compliance/Downside Protection Clauses.
In the area of small balances in particular, many sponsors are also looking for an equity allocator who can bring the added benefit of market experience and asset management expertise that can help them close deals, optimize management and realize potential value. The experience of the fund manager is also a key factor for investors and advisors, as preferred stock investments are often structured with provisions allowing them to access the equity position if the value of the property is impaired.
As it becomes more difficult to break into markets with strong growth fundamentals and secure in-demand assets nationwide, preferred stock investments of $1-5 million may be just the right amount to provide the remaining funding required and the liquidity to complete transactions.
Therefore, a well-structured preferred stock fund serving this space is an important consideration for some investors looking to participate in today’s active market rise and receive strong, current cash flow through a passive real estate investment.
Eli Moghavem is co-founder and director of Base Equities, a nationwide provider of low balance ($1 million – $5 million) preferred shares.