#201 What is Preferred Equity & How Do You Invest in It?

Hey, everyone. Hope you're having a great day. Have you ever heard of the term pref equity or preferred equity? And if you haven't, when investing in passive real estate, you need to know about it. It's shown up in all places in real estate and commercial real estate today, and there's an opportunity for you to get in. Maybe it's something that might work for you in your portfolio. If you want to find out all about it, stay tuned. Welcome to the Passive Income MD Podcast, where we talk about creating your ideal life through multiple streams of income. If you enjoy hearing about this stuff, make sure to hit subscribe. Now, let's get on with the show. All right, everyone, I'm recording this on the back end of the leverage and growth summit that just happened in 2024. For those of you who have been part of it. You know, it's amazing. We get 8 to 10,000 physicians together talking about different ways to create income in medicine, outside medicine, using your medical degrees, leveraging all those skills, all the ambition, all the networks that you've created over time to try something new, to start a new venture, to build some income streams outside of medicine, create that freedom. It's all really exciting and the energy was amazing. I hope you were part of it. If not, I hope you're part of it next year. But as a result, you can probably hear in my voice, I am pumped up. I'm excited. And today we're gonna be talking about a topic that maybe isn't normally that exciting to talk about, but I'm excited about it today. And that's the term pref equity. It's also called AT preferred equity. For those of you who are investing in real estate and syndications, you probably heard about this term and it's called preferred. I'm just gonna refer pref for the rest of this podcast just to make it really easy. It's considered a prep because it takes precedence or preference over what's called a common equity in these investments. And that comes into play whenever there's repayment, but it's after the debt. Now, I'm going to go and explain that a little bit. Every deal that you're investing in, I'm even talking about the deals that you invest in personally. There's usually leverage or some sort of loan on the property, the bank or whoever it is that has a primary loan, that's considered the senior loan or the senior debt. We all know that if that person or that company doesn't get paid first, they can take the property or the Property falls apart. They're the primary position in what's called the capital stack. Now, the capital stack is how all of the money in a deal is stacked up. So if you've got that senior loan, and that's considered the lowest risk in the capital stack, because that needs to get paid first. And this is a simple explanation. But let's say the senior loan is $100,000. This property sells for $100,000. Later on, you've got to pay that loan back first, and. And whatever's left over is profit. So in this case, where the loan is $100,000, you sell the property for $100,000, there is no profit. But let's say you sell for $200,000. The first loan gets paid back, the senior loan gets paid that $100,000, and then you get that $100,000 of profit. So you can see how that first loan gets paid first, no matter what, before anybody else participates in whatever. So that first loan is paid back no matter what, before any of the money goes to anybody else. And it's good to be in that position. But it's usually a fixed amount of return. We all know that banks usually give you a certain amount in terms of the loan in terms of an interest rate. Now, there's some floating interest rates, but for the most part, it is relatively capped in terms of returns. Now, after that, what is the rest of the money that's in the deal? When you buy your own property, you've got the loan, and then you've got the money that you've brought in as a down payment, the money you've contributed not only as a down payment, but also in construction, rehab costs, or whatever cost there might have been where you had to put in some capital yourself. Again, if you bought the property yourself, that's all your own money probably there sitting behind the senior loan. When you're investing in a syndication, there's usually a couple people in the stack. There's that primary loan, and then there's what's called the common equity. All of the investors are behind that senior loan. So again, when that syndication or that property sells, they got to pay back the loan first, the senior loan from the bank, and then they pay the investors, and hopefully there's more leftover for profits that get distributed to everybody. Now, you might have been hearing a lot more about this term called pref. Equity. And where that equity is sandwiched is right between the senior loan and this common equity or the investor equity. It gets preference over your equity. The common Equity, but it is what's called subordinate or behind that senior loan. So it's sandwiched right in the middle there. It's considered lower risk to the investor money, but higher risk to than the loan. Now the way that prep equity is usually structured is a little bit different than either the loan or the common equity. In fact, it has properties of both. It's like, it's like a. It's like almost like a Goldilocks situation where it's not too hot, not too cold. It kind of strikes a balance in terms of risk and reward between the two. Now these things can be structured all sorts of ways. So you have to be careful and also use your due diligence, use your eyes, read well and look at the details to figure out how it's structured. Sometimes it's structured more like debt where it's a fixed rate of return. For example, it might be structured like a 10 or 12% return annually and capped at that. Or it might be structured a little bit more like debt where there's some upside potential. So I'm going to spend a little bit of time talking about what pref equity looks like when it's more like debt and what it's like when it looks a little bit more like common equity. Let's remember it is still equity, but when it looks a little bit more like debt, it might have a pre specified fixed total rate of return. That means that return is capped at let's say, 10%, 12%, 15%, whatever it is, and there's no other participation in the potential upside. If there's any extra money that goes to the investors, there are usually going to be some sort of requirements for how much is supposed to be paid and when. Again, it acts a bit like debt where a loan has to be paid every month. With prep equity that can be a little bit more flexible. You might see situations where it needs to be paid on a monthly or a quarterly basis, or maybe even annually. Or it's accrued, meaning that it's being held for the entire term or it's being held for a specific term and then paid out all at the end. In this case, there might be something called a maturity date where regardless of how long the property is held for and when it's sold, maybe this type of equity needs to be paid back in three to five years. There are usually things like extension options with additional fees. And these are all details you have to look for. When is it going to get paid and how much are you getting paid? Are you getting paid all Upfront, or is there a particular amount that's being paid, like upfront or current, and then a bunch accrued or held to the very end? When is that maturation date? Are there extensions possible with fees? The thing to note is, again, this is paid after the senior loan is paid, but before the investors are paid. Now, if it's structured a little bit more like common equity, this can look completely different. And in fact, it just opens the world to different possibilities. For there might be a small percentage up front, but a small participation on the upside on the back end. That way these investors can expect a certain percentage if the property does not do well, or if it does well, and if it does even better than expected, then they can have a little bit more participation. But again, those returns that are quote, unquote, promised or projected are typically lower than that of the common equity. And the reason why is that it's a different position on the capital stack. It has a different risk profile. The more risk you take, typically the higher returns, the further back you get paid in terms of obligation, meaning you're behind the first loan, you're behind the pref equity, and that's where the investors are. Since you're getting paid last and there's more risk there, you should be getting paid and compensated for taking that additional risk. And we're going to talk about how you can invest in this and how you should be thinking about this. But I want you to really look for two terms that are important to figure out how you're going to get paid as pref equity. There's something called current and something called accrued. And I know I've used both of these words before, but I want to take note of it. Again, if it's current, that means you're getting paid every single month or quarterly, whatever that is, on the dot. Like, like debt, like a mortgage, you're getting paid on the dot. So if they say you're getting paid current 6% or 10%, you can expect that type of return on your money ongoing, regardless of how the property is performing. Now, if something is accrued, then that means that they'll probably hold these payments and you're going to get on paper, those returns are building up, but you may not get paid till later. I'll tell you, there was a deal that we were looking at from a pref standpoint where they promised 20% returns and that sounded amazing, but when we looked at it, there was only about 4 to 6% that was current. They were going to pay on a quarterly basis. And the rest of it was accrued, meaning that they would hold to the very end. There's obviously a risk there. I'm wondering, is this property going to do well to even get you that 20% at the end? Then there was another deal we looked at where the current payment was 12%, meaning that every single month they'd be paying you up to again what that 12% annual payment is, and they pay it every single month for you. Now, there wasn't anything accrued, meaning there was no additional upside, but it was a 12% flat payment. So what would you take the 20% return that had a small portion current and then the rest of it accrued, or would you take the deal that's all current all at the same time? And that's a choice that you have to make depending on your portfolio and what you're looking for, your risk profile, your risk tolerance, what else in your portfolio, how much you trust this operator and where you feel the market is. So how can you as an investor benefit in this? There's been a ton of this new class of equity offered in the marketplace today. The reason why is because of high interest rates, inflation that's still high, which has caused a lot of the values of these properties to be lower. Operators and sponsors have gotten creative and they've had to get creative about their financing, where to get capital, whether they're already in a deal and trying to refinance, or whether they're trying to buy a new deal, where can they get additional capital and do it in a creative way. And so that's why preferred equity has been showing up everywhere. So for me personally, as an investor, I like these type of deals. Personally, I think a portion of my portfolio I love putting towards it because it is heavy, typically on cash flow, yes, on the backside, sometimes the returns are capped, but it creates a little bit more predictability in terms of cash flow. So a couple of deals that I've gone in recently and invested in have been those preferred equity deals where, where they've been higher on the current cash flow, meaning that I've gotten good returns, cash flow basis every single month, and then a couple I've invested in that maybe have a bigger accrued return on the back end. And I'm still investing in some of these standard equity deals as well. All I'm trying to do is round out my portfolio, diversify it, using different types of investments to fit what I want. My ultimate goal is to create cash flow both in the short term and the long term. So hopefully this Helps you understand where pref equity is and your opportunity there. The thing is, just like any other investment, please make sure you do your proper due diligence. It matters who you invest with. What is their track record? Just because they promise great returns doesn't mean they're going to get it for you. Every deal is going to look good on paper. How do you learn how to dig into a deal? Ask the right questions to see if it fits your goals, your risk profile, rounds out your portfolio, creates that diversification, and ultimately gets you the returns and and the outcome that you want. My suggestion to all of you, if you haven't already, spend the time learning how to do the proper due diligence so that when you invest your hard earned money, you know why you're investing in something and why you're not investing in another thing. Let's say down the line these deals go well. You want to say that you were intentionally chose that deal, you did a great job picking it, and you know why it went well. When a deal doesn't go well, which will inevitably happen regardless of how many investments you do, you want to know why you made that decision, maybe what went wrong, what changed, and how you can make better decisions moving forward. You don't want that situation where you just invest because somebody else told you to. And if it goes well or doesn't go well, you don't know why. And basically, the next time you go to invest, you're doing the exact same thing. There are good books on the topics, there are people that you could talk to. For many of you, you want a little bit more of a community and hand holding when it comes to learning about this due diligence. If that's the case, I want to let you know that we have our course and community called Passive Real Estate Academy, where in four weeks you learn how to do the proper due diligence for all of this stuff. It's not for everybody, but if this is you and you want to take advantage of the opportunities that are coming and you're excited by doing this with the community, then our next cohort is opening up soon. Go to passive realestateacademy.com we usually do this one or two times a year, we'd love to have you as part of it. And if you join that community and you take the entire course and you decide, oh, it's not for me, let us know and we go ahead and refund all of your money back. We want to make sure that people are part of this community for the long term helping each other grow, do better due diligence. I absolutely believe that together we're stronger. I hope you learned something from this episode about Prep Equity. It's a great opportunity right now and keep digging and learning to figure out how to create your ideal life through all of these streams of income. Have an amazing week and let's talk again soon. Enjoy the show. Let me know by dropping a review in the podcast app you're listening to us at. And if you haven't already, make sure to hit subscribe. Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. Learn more at our website, passive income md.com thanks again for allowing me to be a part of your journey. See you next time.