Preferred Equity in Private Real Estate: Terms and Definitions
Wellings Capital and its affiliates have invested in commercial real estate, including mobile home parks and self-storage, for years.
We added preferred equity investments to our Wellings Real Estate Income Fund in 2023, and the preferred equity investments are providing meaningful risk-adjusted returns for our investors.
Since there is a lot of jargon surrounding preferred equity, we had some investors ask us to more clearly define the terms.
We created this glossary below for our current and prospective investors to help them understand the various preferred equity terms.
Near the bottom of this blog post, we also answer a prospective investor’s question
Loan-To-Value: Also known as “LTV”. The LTV ratio is calculated by dividing the amount borrowed by the appraised value of the property.
Loan-To-Cost: Also known as “LTC”. The LTC ratio is calculated by dividing the amount borrowed by the total cost to acquire the property. This typically includes the purchase price, fees, expenses, closing costs, and budgeted capital improvements.
Lower Attachment Point: The LTV or LTC where debt ends and preferred equity begins.
Upper Attachment Point: The LTV or LTC where preferred equity ends and common equity begins.
Detachment Point: Same as “Upper Attachment Point.”
Last Dollar Exposure: Same as “Detachment Point” and “Upper Attachment Point.”
Current Pay: The portion of the Coupon Rate that is paid from operations or reserved up front. Wellings is typically seeing 7-10% annual current pay.
Current Pay Reserve: If a deal doesn’t have sufficient cash flow to cover the full current pay right away, the Preferred Equity Partner might structure a current pay reserve to cover the full current pay until the property can cover the current pay from operational free cash flow.
Coupon Rate: The total projected annual return to the Preferred Equity Partner. This return is typically not realized until a refinance or sale. Wellings is typically seeing 14-18% projected annual coupon rates/total annual return.
Accrual: The accrued portion of the coupon rate that is paid at a capital event.
PIK: Payment in Kind. Same as “Accrual.”
DSCR: Debt Service Coverage Ratio: Net Operating Income divided by Debt Service.
Global DSCR: Net Operating Income divided by the sum of Debt Service and Pref Current Pay.
Personal Guarantee: A contractual guarantee by the sponsor or Key Principal to cover the Preferred Equity in the event of a default. Similar to a full-recourse personal guarantee on a loan.
Major Decision Rights: Actions and expenditures that require the approval of the Preferred Equity Partner.
Manager Removal & Replacement Rights: The Preferred Equity Partner’s right to remove and replace the Sponsor as Manager if defaults are triggered.
Forced-Sale Provision: The Preferred Equity Partner’s right to effect the marketing and sale of the asset(s) if any Default Provisions are triggered.
Lender Recognition: Formal recognition by the Senior Lender of the Preferred Equity Partner’s rights and remedies.
Default Provisions: The conditions under which control rights are triggered. May include missed debt service payments, missed Pref Current Pay payments, failure to achieve and maintain predetermined rent growth, Net Operating Income, Debt Service Coverage Ratios (including Global DSCR), etc.
Capital Improvement Reserves: Funds earmarked for capital improvements that are held back by the Preferred Equity Partner and released in draws as progress is made. Sometimes the draw approval will require results from former improvements to be achieved in regard to rent growth or expense reduction.
MOIC Floor: AKA Minimum Multiple. A minimum Multiple on Invested Capital that is triggered if the Preferred Equity is paid off before that multiple is achieved through the Coupon Rate. Similar to a Prepayment Penalty on a loan.
Equity Kicker: Common Equity shares granted to the Preferred Equity Partner in addition to the Coupon Rate that allow the Preferred Equity Partner to participate in the waterfall after being paid off.
Promote Participation: GP Promote shares granted to the Preferred Equity Partner in addition to the Coupon Rate that allow for the Preferred Equity Partner to participate in the Carried Interest, or Promote, of the General Partner.
Current Pay Reserve: A reserve account controlled by the Preferred Equity Partner that is drawn upon to meet the Current Pay payments.
Cash Flow Sweep: The Preferred Equity Partner’s right to all cash flow from operations until the cash flow covers Current Pay entirely, until a predetermined Global DSCR is achieved, or until the Preferred Equity Partner is paid off.
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A Question About Preferred Equity From a Prospective Investor
We received this question below in response to an email we sent to our list sent back in May 2023, and we thought it was worth answering publicly.
Question
Hi Paul,
I can see why you're excited about this. I wasn't able to attend the webinar, so forgive me if this was answered there, but why is the sponsor interested in giving you preferred on these terms? If they couldn't fill that part of the capital structure with more debt, why not just raise more equity instead of giving you sweetheart preferred terms?
Answer
Experienced sponsors realize that preferred equity is actually less expensive for the sponsor in the long-term, compared to raising additional LP equity.
Because once the preferred equity is paid off via a refinance, preferred equity is out of the deal.
The only caveat to this is that in some deal structures, there may be an equity kicker or promote participation structured into the arrangement.
Let's look at the same hypothetical deal across three scenarios:
Scenario 1
60% senior debt
35% LP common equity
5% GP co-investment common equity
70/30 LP/GP split
In this scenario, if the sponsor can execute on the value-add plan, refinance out that forced equity and return capital to LPs, that will eliminate the preferred return to LPs, but they will still be splitting the upside 70/30. This means that they will be getting 38.75% (30% promote plus 8.75% from owning 12.5% of the LP).
Scenario 2
60% senior debt
20% Preferred Equity
15% LP common equity
5% GP co-investment common equity
70/30 LP/GP split
In this scenario, the sponsor will be getting 47.5% once the Preferred Equity Partner is taken out (30% promote plus 17.5% from owning 25% of the LP).
They have effectively doubled their share of the LP interests by allocating half of the equity to pref, and without putting any additional money out of pocket into the deal.
Scenario 3
60% senior debt
20% Preferred Equity
20% GP co-investment common equity
No split because no LPs
In this scenario, the sponsor will be getting 100% ownership in the deal once the PE Partner is taken out: no split; no reporting; no investor relations; no need to sell according to a projected investment horizon; just full ownership of the deal.
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Savvy sponsors recognize that although pref is expensive in the short-term, is actually far less expensive in the long-term than giving up the majority of the upside to common equity LPs.
If there is a portion of common equity, pref can be accretive to the returns of the common equity LPs as well.
Wellings recognizes that the risk-adjusted return profile of being a PE Partner in the current market is particularly compelling: equity-like return profile; priority of cash flows from operations; priority of repayment of principal at a capital event; partially risk-mitigated position in the capital stack with first-loss common equity subordinate to it; control provisions and forced-sale rights; etc.
The specific deal referenced in our email blast is similar to Scenario 2 above, but we are at about 75% LTC instead of 80%.
Another that we have under LOI is similar to Scenario 3 (no LPs but not exactly the same debt/pref/common ratios), and our terms are 10% current pay and another 8% accrual, if we move forward to funding it.
One thing worth noting on that: with pref structured where the accrual is paid before any return of capital to common, in order for our current pay and accrual projections not to be achieved, that basically means that common equity (LPs and GP) would have lost all of their principal.
If you have any questions, please email us at invest@wellingscapital.com or use this link to set up a call.
This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. All investments involve the risk of loss, including the loss of principal. Past performance and any performance results reflected in this article are not an indication of future results.
