Investors Embrace Preferred Equity to Mitigate Risk and Increase Returns

Did you catch this year’s “Woodstock for Capitalists” event in Omaha? I tuned into Berkshire Hathaway’s annual meeting to experience it first-hand; with Warren Buffett aged 93 and Charlie Munger approaching 100, any year could be their last!

Munger’s statement about commercial real estate was troubling-but not unexpected.

Munger had long warned of an impending storm in the U.S. commercial property market, with American banks chock-full of subprime loans as property values declined rapidly. At that meeting, Munger reiterated his concerns and Buffett reinforced them further.

Over time, investors flocked to real estate’s rising tide for higher and higher returns, asking: “How much money can I make?”

However, investors are wondering “How much could I lose?”.

Such is the nature of these times for investors; instead, they switch focus back onto risk-adjusted returns instead.

Calling all Recovering Speculators
As an old speculator myself, I know the challenges associated with risk-adjusted returns can be formidable. Now, however, my firm specializes in these metrics which offers much greater potential return than its former self.

Investors typically seek risk-adjusted returns. But sometimes unexpected opportunities present themselves–deals that don’t appear when cash and profits are rolling in like St. Patrick’s Day parade proceeds in Chicago.

Right now we are experiencing one of those rare moments.

Preferred equity offers many advantages to investors in first loss position, including increased safety due to its higher position in the capital stack, immediate cash flow and management rights in case of delinquency as well as providing a buffer against decreasing asset values.

Be clear: this does not refer to the preferred return investors receive as part of their payout structure from syndicators; although that can be great, that isn’t what I mean here.

These investments stand in stark contrast to the usual preferred equity offerings from multifamily sponsors or sponsors in general, which often offer investors debt-like cash flow streams (typically between 8-10%) with limited or no upside potential.

Investors typically trade lower potential returns for cash flow and a safer position in their capital stack, and we believe this is an ideal time for them to consider such strategies. But I am talking about something else.