INTRODUCTION TO PREFERRED EQUITY
By: J SCOTT
If you’re an investor these days looking for ways to protect your hard-earned capital, understanding the concept of capital stacks and preferred equity is very important. But, while these are both pretty simple concepts, a good explanation is going to require more than a sentence or two.
But, again, if you’re an investor – and especially today – understanding these concepts will provide a whole new insight into how you should be thinking about your investments and their risks.
I like to think about concepts in the form of building blocks. Start with the simple and work up from there.
When it comes to this topics, the most basic building blocks are the thing we use to buy investments – money. So, let’s start there…
Debt & Equity
In order to complete any investment, you need money. Whether you’re buying a single family rental for $100,000, purchasing Twitter for $44B or anything in-between, the currency used to purchase investments is cold hard cash.
Now, this cash can come in different forms and from different places. But, the cash for every single investment on the planet falls into one of two categories: Debt or Equity.
Debt is simply a fancy name for a loan. Borrowing money. That’s the first way to gather cash to make an investment.
Someone provides capital in return for the eventual return of that capital, plus some amount of interest. For example, when many of us buy a rental property, we typically get a loan from a bank for about 70-75% of the total purchase costs.
Equity is simply a fancy name for money that generates ownership. If I get a loan for 75% of the cost of a rental property from a bank, the bank doesn’t own the property (it has some level of oversight and control -- it can foreclose if mortgage payments aren't made -- but it has no formal ownership). The owner is the person – or people – who put in the other 25% of the costs.
If it’s me buying the property myself with my own cash to cover the 25%, I am the owner. Or maybe I bring in partners to split the cost with me. Now, my partners and I are owners. Or perhaps I bring in passive investors to cover some or all of the costs. If so, they are all owners as well.
This investment of cash comes with more risk – if the investment doesn’t do well, we lose money.
But, it also comes with more potential reward – if the investment does do well, we make money.
The cash put into the investment in the form of ownership – sharing in the potential upsides and downsides of the deal – is the equity.
Again, for every investment, the money that is used to get the deal done is some combination of debt and equity.
And the combination of debt and equity that goes into a specific deal is called the Capital Stack for that deal.
The Capital Stack
Yup, a capital stack is just a fancy name for a combination of debt and equity. And to visualize the debt and equity going into a deal, we can draw the capital stack.
For example, here is what the capital stack would look like if I purchased a $100,000 rental property with a bank loan for 75% of the cost and the additional 25% in equity (cash) coming from me and my partners:
There’s a reason why we draw the capital stack with the debt on the bottom and the equity on top. To understand the reason, think about income and profits coming into the investment.
To visualize how income and profit get distributed to those in the capital stack, imagine that that income and profits is being poured into the capital stack. The first income/profits received start filling up the capital stack from the bottom, being used to pay the debt holders the interest they are owed.
As more income/profits roll in, they start to fill the stack and eventually – once the debt holders have been paid the interest they’re owed – the rest of the money flows up to the equity holders. It’s only after the debt holders get what they are entitled to that the equity holders start getting paid. If the income/profits run out before the equity holders can get their share, the debt holders get everything and the equity holders get nothing.
Because the debt holders get paid first, they have a whole lot less risk.
But, once the debt holders get paid the interest they are owed, all the rest of the money goes to the equity holders. If there’s a whole lot of profits, the equity holders may end up with a windfall.
While the equity holders have a lot more risk – they are paid last – they also have a lot more reward:
This is the reason why debt is almost always a less expensive option than equity. A lender is going to be willing to accept a lower return (fixed interest payments) because the lender has a whole lot less risk. They get less profit, but they get paid first.
Equity holders (partner, passive investors, etc.) are going to expect higher overall returns because they are taking more risk. They get paid last. And they want to be compensated for this risk.
Now, while all the money going into an investment is a combination of debt and equity, that doesn’t mean that all equity debt and equity are the same.
For some investments, it makes sense to have different levels of equity. The most common example of this is a form of equity called Preferred Equity.
Preferred Equity is a form of equity in the sense that it conveys ownership of the investment to the equity holder. But, Preferred Equity has some advantages over regular equity (which we often call Common Equity).
The most obvious is that it is positioned in the capital stack below the Common Equity:
If you recall from our previous discussion, this means that the Preferred Equity holders will get paid before the Common Equity holders.
This results in less risk for the Preferred Equity holders. Once the debt holder gets paid, all the remaining profits will flow to the Preferred Equity holders until they get all their profits. Only then, if there are additional profits remaining, will those profits flow to the Common Equity holders.
Because Preferred Equity investors have less risk, they typically get lower returns than Common Equity holders. But, during times of economic turmoil – like we’re seeing today – the risk/reward tradeoff of Preferred Equity is often better than debt or Common Equity. In addition, Preferred Equity holders typically have an agreement with the operating team that allows the Preferred Equity holders to take over control of the property should agreed upon distributions not be made (much like the lender has the ability to foreclose).
In other words, when the markets are volatile, Preferred Equity investors often provide the biggest bang for the buck, with the least amount of risk. You give up a little bit of returns, but in exchange, your likelihood of losing a bunch of money goes down considerably.
It can be difficult to find Preferred Equity investments these days, but as the market continues to get more volatile, operators are starting to recognize the value of providing these safer investments, and they are becoming more popular.
Long story short, when making investing decisions, it's important to understand what the overall capital stack looks like -- what percentage of the funds are allocated to debt versus equity, and what types of equity are being offered -- in order to understand whether you should consider investing in the deal and into which type of equity.