{"id":160834,"date":"2023-10-18T15:17:50","date_gmt":"2023-10-18T21:17:50","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=160834"},"modified":"2023-10-18T15:17:53","modified_gmt":"2023-10-18T21:17:53","slug":"preferred-equity-can-improve-your-returns-in-this-environment","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/preferred-equity-can-improve-your-returns-in-this-environment","title":{"rendered":"Preferred Equity is One of the Best Ways To Earn Double-Digit Returns in This Economic Climate"},"content":{"rendered":"\n

Do you know what Warren Buffett did when the financial world was gripped with fear and uncertainty? And what can you and I learn from it? <\/span><\/p>\n\n\n\n

I want to be clear: I\u2019m not saying we\u2019re in a financial free fall. This is not 2008. But recent real estate and financial market news points to a downturn we haven\u2019t seen since that era. A significant amount of carnage is already unfolding, and many commercial real estate deals <\/span>are heading south<\/span><\/a>. <\/span><\/p>\n\n\n\n

This is not a rosy moment in real estate paradise. We\u2019ve all seen some of the worst deals done in the best of times. Now, we\u2019re watching for some of the best deals to surface in some of the worst of times. <\/span><\/p>\n\n\n\n

So, what types of deals are available right now? Honestly, they\u2019re not that great\u2014unless you know where to look. <\/span><\/p>\n\n\n\n

The types of deals formerly penciling internal rates of return (<\/span>IRRs<\/span><\/a>) in the mid-to-high teens are now coming in at about 11% to 13% or less.<\/span> <\/span><\/em>That\u2019s if you can find them. <\/span><\/p>\n\n\n\n

And economic uncertainties are causing some to sit this round out. While that\u2019s an option, we hate to see investors sitting on cash or Treasuries and breaking even or losing money to ravaging inflation. <\/span><\/p>\n\n\n\n

If Buffett\u2019s actions in this downturn are a repeat of what happened last time, we expect to see him making similar moves to what he did in 2008. <\/span><\/p>\n\n\n\n

So what did Buffett do then, anyway? <\/span>He hedged his portfolio by changing his position in the <\/span><\/em>capital stack<\/span><\/em><\/a>. <\/span><\/em>Berkshire Hathaway acquired $5 billion of Goldman Sachs stocks when most wouldn\u2019t touch them with a 39-and-a-half-foot pole.  <\/span><\/p>\n\n\n\n

But Buffett didn\u2019t take the risk other investors took. Instead, he dramatically lowered his risk by buying preferred equity shares on Sept. 23, 2008.   <\/span><\/p>\n\n\n\n

And we believe you should do the same thing right now\u2014<\/span>if you can get access to it. <\/span><\/em><\/p>\n\n\n\n

Why We Love Preferred Equity <\/span><\/h2>\n\n\n\n

Preferred equity is <\/span>a hot topic right now<\/span><\/a>. My investment firm, <\/span>Wellings Capital<\/span><\/a>, is pursuing preferred equity deals to add to our fund. We believe the current financial situation creates a unique window of opportunity. <\/span><\/p>\n\n\n\n

So, what do we like about preferred equity? While there is no lien, preferred equity may provide more upside and tax benefits than senior or mezzanine debt. Preferred equity sits between debt (first lien position) and common equity (which has no lien but most of the upside profit\u2014or potential loss). It has some of the advantages of both equity and debt.<\/span><\/p>\n\n\n\n

Like debt, preferred ongoing equity payments are established in advance, and all, or a portion of, these are paid before common equity distributions. At the time of sale or refinance, preferred equity holders are typically caught up (if behind) before common equity holders receive distributions. <\/span><\/p>\n\n\n\n

Here is a look at where preferred equity falls in the capital stack:\u00a0<\/span><\/p>\n\n\n\n

\"graph<\/figure>\n\n\n\n

Buffett invested in preferred equity when times were rocky. Likewise, we believe this is a uniquely strategic time to hedge some of our investments by adding preferred equity to our portfolio.  <\/span><\/p>\n\n\n\n

We are pursuing preferred equity investment opportunities that provide 8% to 10% cash flow and total returns of 15% to 19%. Not only are these returns higher than most deals are penciling now, as mentioned, but the risk is also theoretically lower, and the payments should be far more reliable. However, clearly, there are no guarantees. <\/span><\/p>\n\n\n\n

So What\u2019s the Catch? What Does This Cost Investors? <\/span><\/h2>\n\n\n\n

The downside for investors is limited upside. The maximum total return is typically predetermined in exchange for higher certainty of payments and returns. And preferred equity is prioritized ahead of common equity. <\/span><\/p>\n\n\n\n

Preferred equity, like every other investment, carries a risk-reward tradeoff. No one knows the outcome of any investment. <\/span><\/p>\n\n\n\n