Understanding the Power of Pref Equity

Ed Aloe (00:03):

Welcome to the Real Estate Wealth Podcast, the show about how you can build wealth by investing in real estate. I'm your host, Ed Aloe, founder and CEO of CALCAP Advisors. I'll dive deep into multifamily investing and today's current market. I'll also help you acquire the knowledge and tools necessary to generate passive income for life through discussions with friends and experts in the industry.

(00:29):

Today, I would like to welcome John Pappalardo into the podcast. John is director of business development for our preferred equity company called CALCAP Strategic Opportunities. John has been with us for over four years now. He was initially hired as an analyst in our asset management business before being promoted to his current role. John is young but very mature and knowledgeable beyond his years, and we are extremely happy to have him on the team at CALCAP and happy to have them on the show today.

(01:00):

So John, welcome to the Real Estate Wealth Podcast.

John Pappalardo (01:03):

It's good to be here, Ed. Thanks for having me on.

Ed Aloe (01:06):

So John, let's talk a little bit about the preferred equity or what we call pref oftentimes. But before we jump into that, I kind of want to give our listeners an opportunity for you to talk about your background, kind of how you got to where you are today and how you got started in this business.

John Pappalardo (01:22):

Yeah, sure thing, Ed, and I think my story is probably similar to a lot of guys in the business and it started with a realization that paper assets may not be the best thing for me. So my degree was in business finance, my coursework was mostly in equity tradings, but that never really felt like the right fit for me. I'm a very tactile guy and while I believe equities have a place in everyone's portfolios, it just wasn't something I was all that interested in. And at the time, and still to a certain degree now, I just felt that a lot of companies, especially kind of in the tech space had share prices that were just wildly detached from financial performance of the companies.

(02:07):

So the more I learned about real estate as an asset class, the more it just made a lot of sense for me. One, you own a real asset, you can see it, you can touch it, we drive it, we drive comps, and you own something physical. And two, you have a lot more control over the value of the asset because intrinsically the value of your asset is tied to the income it produces. There are nuances with cap rates and market fluctuations, but fundamentally you control the performance of the asset and the value's asset is based on performance. So the asset class just made a lot of sense to me. And personally, the fundamentals of housing, in my opinion, are just the best of any asset class. We're under supplied nationally, and I don't think that problem's going away anytime soon.

(02:56):

So at first for me, it was a lot of self-education, reading, podcasts like this one and just meeting with like-minded people. But when I made the decision and decided it was time to pull the trigger, I quit my job in risk management, I started working at C2 Financial, which was a pretty productive residential mortgage originator headquartered down in San Diego. And my plan was to just learn as much as I could and then move into multifamily when the right opportunity came up.

(03:30):

I ran across CALCAP, you guys needed an acquisition analyst, you were buying apartments in the Southwest and a lot of the markets that I was really interested in like Phoenix and Las Vegas, and it was a great fit. I joined the acquisition team. I spent three years doing acquisitions and we had a really great team in place and I thought we bought a lot of great deals in that time. Last November, I transitioned over to the preferred equity business and I've been sourcing preferred equity deals for us for a little over a year now. And we've been looking at a lot of great pref deals and I feel like we're in a really good place in the market to be able to execute on some of these pref opportunities.

Ed Aloe (04:12):

So John, why don't we talk a little bit about preferred equity. We kind of say that it's really debt disguised as equity, which it kind of is for a lot of different reasons. But why don't you give our listeners kind of just a broad overview of what preferred equity is and how it fits into the capital stack for investors?

John Pappalardo (04:34):

Yeah, certainly Ed. And I think gap financing is a very apt term for it because like you said, it does kind of bridge the gap between debt and equity. It kind of exists in the middle of those two things. It inhabits the same position in the capital stack as a second loan or mezz financing. So when I'm talking to a new sponsor who hasn't worked with pref, I usually say that that's a good place to start thinking about pref. It behaves and it is a lot like a second position loan, like a mezzanine loan. It's subordinate to the senior financing, but it's senior to all other equity in order of payback. So it functions a lot like debt in the sense that generally it's a fixed return with no profit split over and beyond kind of the stated rate of return.

(05:27):

So with preferred equity, you don't have an uncapped return like you do in common equity, but you do have priority in terms of both distributions and payback when the sponsor goes to sell the asset. So it behaves a lot like debt and we talk about it in terms of leverage and interest rates when we're talking about it. But it truly is an equity investment. It's governed by an operating agreement very similar to a joint venture equity structure, and it's not secured on title. So it is true equity, it just behaves like debt.

Ed Aloe (06:04):

And so what are the main reasons that sponsors look to use this GAAP financing, if you will? When I look at it... And we're not users of it when we acquire, but a lot of investors are, and I think it's really a couple reasons, John, like you and I have talked about. Either they have trouble raising the required equity, so they need a preferred equity partner to kind of bridge that gap of what they need to come in with to close the transaction and/or some investors just look for a little more leverage to enhance the returns. And they believe preferred equity is a good solution because it doesn't participate typically in the profits like the common equity does. It's a fixed cost and it's relatively expensive, but when you consider the fact that it doesn't have profit participation in the backend I think a lot of sponsors think that it's really not expensive and it's cheap in the overall scheme of things.

(07:05):

So can you talk a little bit about when people come to you looking for preferred equity, what reasons you're seeing out in the marketplace and how guys like to use it?

John Pappalardo (07:15):

Yeah, certainly. And you really touched on the two main reasons that sponsors do come to me looking for preferred equity. The first one, like you said, is it's because it's accretive to their returns. Now, it's a lower cost of capital than common equity. It's more expensive than debt, but it's a lower cost of capital than common equity. If we have a, call it, 13 or 14% fixed return and the sponsor knocks it out of the park and achieves a 20, 30% member return, the preferred equity doesn't participate in that upside. So that upside gets split among the common equity investors and it really juices their returns because they have an equity tranche that they don't have to pay upside to. So that's a big reason for a lot of the sponsors who are coming to me using preferred equity.

(08:07):

And then the second that you mentioned was ease of access to capital. And it might not be that they don't have the ability to raise the money. It might be that they have $10 million to raise to buy an apartment building and their average check size is 200,000, so they're going to have 50 investors that they're collecting checks from. Versus if they come to a pref group, they're going to write a single $5 million check and it's going to cut their number of investors you need in half. So it's either that, A, they don't have access or B, it's just easier to get a big chunk of your equity from one source, from one check. So it's just ease of access to capital. Pref guys have discretionary funds a lot of the times and it's a lot easier to get a pref check than to have to make 40 or 50 calls to get the same amount of equity. Those are the two main reasons that sponsors are telling me when they're coming in for preferred equity.

Ed Aloe (09:04):

Let's discuss a little bit about the term of the preferred equity, I guess loan we'll call it for lack of a better term or preferred equity investment, it's probably more apt. What does the term look like that we're usually looking at and how does that kind of play into the first trust deed?

John Pappalardo (09:23):

Yeah, certainly Ed. And usually we're targeting a three to five year time horizon, that's kind of what we're targeting on our side. It's a good time horizon for us. So the term will typically be coterminous with the senior loan, and there's some nuances with that and there's a reason there's a difference. If you are looking at, say, a 10-year Fannie or Freddie loan, the pref will technically be termed as 10 years. It's not going to expire until the end of 10 years when the loan expires. Most pref guys aren't interested in being in these deals for 10 years, so we'll have mechanisms to exit the pref in three to five years. But three to five years is our time horizon, it's a really good time horizon for us. Gives the investor time to execute their business plan and then either get us out with a sale if that's their intention or a refi if they want to hold onto the asset and refi, pay the preferred equity off and continue holding the asset.

Ed Aloe (10:31):

We've kind of designed our business more and more to sort of get away from shorter term bridge debt, that's expensive and floating and with rates going up has become really onerous for a lot of sponsors to handle. Where we'd rather be lower leveraged in the stack, so we want our SLUG, our preferred equity piece to be at a lower loan to value or lower loan to cost and preferably behind fixed rate debt. And so typically that fixed rate debt on multifamily is going to come from the agencies Fannie Mae or Freddie Mac.

(11:08):

Let's talk a little bit about that. We'd prefer to be behind the agencies. Let's talk about how that debt structure looks today, John, in terms of where they might be on their underlying first debt piece, where we are in the middle, how much common equity is coming in, and talk a little bit about different kinds of preferred equity because there's really soft pref and hard pref.

John Pappalardo (11:35):

Yeah, there is, and there are important distinctions between soft and hard pref there. The two main kind of pref that's out there on the market is hard and soft. The main difference, and really only difference between hard and soft pref is that in hard pref, there's a minimum dividend that needs to be paid. And if the minimum payment on the pref cannot be paid, it's considered a default. Sort of like if you can't pay your loan. Really, Fannie almost doesn't let you do hard pref. Freddie does, but it's pretty onerous. Because Freddie and Fannie want control over who's going to be managing the asset, they're writing the loan for the sponsor. And so a pref group stepping in and taking over if they're not paid is not something Fannie and Freddie really like.

(12:27):

On Fannie Mae and Freddie Mac that frequently the pref is going to be what's called soft pay pref. And what that means is there's a minimum dividend that we would like to have paid, but if there's insufficient cash flow to pay the minimum dividend to the pref, then it's just going to accrue until such point as the deal can support paying the minimum dividend again. It's not a manager default to not pay the pref, provided there's cash flow available to pay it. So that's really the main two differences between soft pay and hard pay pref.

Ed Aloe (13:04):

So John, why don't you kind of walk our listeners through a typical structure of what a pay rate might look like today, what the accrue rate is and how that all works?

John Pappalardo (13:16):

Yeah, certainly. It's easiest to think about it in there is a total return that needs to be paid on a preferred equity investment, and that return is going to be defined from as soon as we send an LOI or as soon as even we give a soft quote. There's a total return that the pref demands. And that might be 13 or 14% more or less depending on aspects of the deal. But there's the total return. But then not all of that's going to need to be paid. A portion of that, as you mentioned, can be current pay, call it 8%, that's 8% per year and that's paid monthly. And then the balance can accrue until the pref is exited. And that accrued pref is non compounding, it's a simple return. So that's kind of what we're talking about when we say a pay rate and an accrue rate, A portion of the total return will need to be paid monthly and the rest can accrue, and that's the difference.

Ed Aloe (14:17):

So John, let's talk a little bit about control rights. And a lot of people I think confuse preferred equity with mezzanine financing or second financing, but it's very different. You kind of touched on and alluded to an operating agreement versus mezz debt or secondary financing where you really have a lien against the property. With preferred equity, we do not have a lien against the property. We have a separate operating agreement. We create a SPV with the sponsor. So do you want to talk about how it's structured and how it's different from mezzanine financing?

John Pappalardo (15:01):

Yeah, sure thing. And I think that that's an important question for sponsors. One of their most important questions when we're talking to a new sponsor is what do the control rights look like for a preferred equity investment? And any investor who's familiar with joint venture equity, JV equity, the control rights in a preferred equity in investment agreement and a JV investment agreement are going to be very similar. And the thought here is that the preferred equity partner is investing a significant amount of the capital into the deal. So in exchange, we get control rights and protections, and part of our control rights is what we call default protections, what our default protections, which effectively state that if the sponsor is poorly managing the asset. And that can be either by letting the condition of the property deteriorate or if they're severely struggling with operations and can't seem to turn it around, then the preferred equity partner has a right to step in as the manager and right ship. That's really not something we want to do in any scenario. From the beginning we're diligently underwriting these deals and we only do deals where we have full confidence that the sponsor will be able to execute their business plan. But we are owner managers ourselves and we're fully capable of stepping in and righting ship if need be. So that's kind of the fundamentals of the control rights we have.

Ed Aloe (16:37):

And we also have a mechanism that would be default interest if somebody defaults on us, that 13 or 14% would then go to I think 17 or 18%, our default rate, while they are defaulted. And that could be the lack of being able to pay us on a monthly basis and/or when that loan matures, like we talked about, in three years, you said you were going to pay us off and now it's three years and you can't, that would also then be called a maturity default, right John?

John Pappalardo (17:09):

Yeah. So besides stepping over and stepping in and declaring a manager default, our other remedies are both, as you mentioned, the drag to market or the ability to unilaterally refinance the property to take us out. And those are really our main protections that are better for us, that we're more interested in. Because our goal and our interest is never stepping in and managing these properties. Like I said, I mean, we have full confidence in our partners that they're able to manage these assets that we're investing in. And there has to be a lot of alignment there between the sponsor and the pref investor, and that's why we're very selective with the sponsors that we do business with.

(17:52):

But in cases where there is a default and it cannot be cured by the sponsor, really outside of stepping in and managing the property and managing the asset, we also have the ability to unilaterally list the property for sale and used our best judgment to get the best price that we can for the deal. Both pay off the senior lender, our pref, and then if we take over, it's not that there's incentive for us, we don't get the upside. It still goes to the common equity and common equity in the sponsor. Our incentive purely is to protect our preferred equity if we are going to do a sale and/or refinance, we're allowed to go out to market and refinance the loan as well, which can take out our pref if a default is not cured and occurs.

Ed Aloe (18:46):

And I think you bring up a good point. So the common equity, the sponsor partner, is still technically in the deal. Even if they've defaulted and we have to take over management of the transaction, they still will get paid, provided there's enough equity in the deal to pay off the underlying first lender ourselves, and then whatever's left over for the common equity investment. Which I think honestly makes us a stronger partner for sponsors in the business, then a pure lender who gets involved in preferred equity, where really their only choice would be to drag it to market. I think we have a lot more tools and flexibility to try to work through a bad scenario to ultimately get the best outcome for us, the underlying lender, and the common equity. Do you agree with that, John?

John Pappalardo (19:37):

Yeah, no. I completely agree with that. And that's a big selling point when I'm talking to other sponsors. We've been doing this for 15 years, we're owner operators, we have a lot of acquisition experience, and that makes us a better partner. Even in scenarios where maybe the sponsor is just slightly struggling with the asset and occupancy's gone down and we can lend our advice and our wisdom to the sponsor based on our portfolios and how we've kind of weathered similar storms.

Ed Aloe (20:11):

So, let's talk a little bit about how you look at underwriting the deal and how you look at underwriting the sponsor on preferred equity.

John Pappalardo (20:20):

Yeah. That's a great question because for me and for us, the sponsor we work with is equally important to the deal that we're investing in. And CALCAP's been underwriting deals for 15 years. I spent three years on the acquisition side, Josh Holman, who has been with CALCAP since employee number one. And so we're very good at underwriting multifamily investment opportunities. We have conservative practices and we use the same practices we do on the pref deals as if we were buying the deal ourselves. So not only are we using the same models to underwrite these deals, but everyone who's worked at CCSO and who is working at CCSO has acquisition experience, and that's kind of one of our big selling points to sponsors like I was talking about. But we look at these deals through the lens of owner operators and not the lens of a lender.

(21:22):

So when we're looking at partners, the questions that we're really asking ourselves, kind of two main questions is, one, how is the sponsor character? Do they have character? If times get tough, can we rely on them to work in their and our best interests to do right by the deal? So that's the first thing we ask ourselves. And the second thing we ask ourselves is there synergies in the way that they work on deals and they see deals and the way that we see deals? Because the times get tough and we're in an asset together, we want to know that the sponsor is going to make the right calls. And so our goal is we want to have mutually beneficial partnerships with these sponsors and create programmatic relationships so that after they've demonstrated that they can perform, we can do more deals with these guys and have programmatic relationships.

Ed Aloe (22:20):

That's right. And I think, I mean you touched on it, integrity and reputation of these sponsors is something we really try to vet out because it's important. It's not a joint venture, but being a preferred equity partner is pretty darn close to it because if things go south, you want to make sure you have a partner that's going to be coming to the table and able to work with you if things become difficult and not become adversarial. Which I think is important to note.

(22:54):

So let's talk about that, kind of our guidelines today and where we like to be. I think we're probably more conservative than some, but also priced probably better in that regard than some preferred equity deals you see out there at 18%, but they're higher in the leverage stack, to your point, a riskier transaction. We'd rather be lower in the leverage stack and offer a lower rate, if you will. So do you want to talk about kind of LTV, LTC guidelines and what we're seeing in the marketplace right now in terms of underlying debt, where that's coming in and sort of where we fit in that gap, that middle piece?

John Pappalardo (23:38):

Well, yeah. So what we're looking at when we're talking about... And the kind of deals that we're looking at right now and the kind of deals that we're targeting are deals where a sponsor is getting a senior loan from Fannie or Freddie, that's most of what we're looking at right now. And their proceeds are falling short of where they'd like them to be. Where they would hope to get kind of 70% loan to value senior debt from the agencies, the agencies are having a tough time getting to that level and being competitive at that level because rates are up and they have pretty rigid coverage requirements. So what should be a 70 or 75% loan to purchase price senior loan might be a 55 or a 60% loan to purchase price senior loan. And that's creating a gap in the market with guys who want to fill that with either additional debt or something that they can treat like that, to get a little extra leverage.

(24:45):

So that's a lot of what we're looking at right now is sponsors who are proceeds constrained for one reason or another and they just need a little more leverage to get there.

Ed Aloe (24:56):

Let's touch on that a little bit and what happened and why that happened. So when we look at and explain kind of debt cover ratios. So the reason where Fannie or Freddie might have been at 75 loan to value two years ago and now that same transaction they may be at a 55 or 60 is really a result of interest rates going up. So, that loan a couple years ago might have been 3.5% and now it's, call it, 5.5%. So that 200 basis point spread now has to be what we call covered, the debt cover, and so that impacts the amount of proceeds. That impacts the size of that first. So can you kind of explain that, John, how that works and what those coverage ratios are that they're using?

John Pappalardo (25:46):

And let me just walk it back a little bit and say that when you're getting a business purpose property loan, what they're looking at is your ability to service that loan based on the income that the property produces. So Fannie and Freddie and most lenders are concerned with, "Okay, if we give them a loan on this building, how much debt service can they support based on the market interest rate that we're going to charge them?" Say, today the rates are at five three or so. So with a 5.3% interest rate, and they look at these loans amortizing, by the way, how much can they be able to support that loan payment plus a little bit of extra coverage, in this case about 25%.

Ed Aloe (26:43):

Last thing here, let's talk about the current marketplace. Where you see the market going in the next six months to several years out and why we think there's going to be a lot of opportunities in the preferred equity space, at least over the next couple of years.

John Pappalardo (27:02):

Certainly. I think it's going to be more of what I've been seeing in the last quarter, I'll probably be seeing for the next year, potentially two years. What that is that for the last three years the markets were very bridge dominated. So what I'm seeing in the pref market is a lot of sponsors are looking to refinance their floating bridge debt into fixed rate agency product with rates in the low mid five handle. But we talked about, it's tough to cover on those because they're pretty conservative on their coverage requirement and they're coming of up short on proceeds to take out the bridge loan. So they're having to do cash in refinances, which is driving a lot of business my way because perhaps a good place to get a few million bucks if you're short on your refinance and you got to pay off your other loan.

(28:00):

So we're going to continue on our side targeting kind of the lower leverage agency borrowers, that's been our directive for the last year or so. When I stepped in end of 2021, that was really my directive. And I think we were a little early at that time, there wasn't a lot of agency debt, the rates hadn't crept up yet. But now we're in a really good position to take advantage of that because the market has kind of caught up to us. So I think in the next two years we're going to see a lot of those kind of opportunities. We're going to see some pain from the guys who are having to service 8% interest rate floating bridge loans and they're not able to get taken out. That's just the kind of stuff that we're going to be seeing in the next couple years. But I feel good about our position.

Ed Aloe (28:53):

Well thanks John for joining me on the Real Estate Wealth Podcast today. I think it was an interesting conversation kind of explaining what preferred equity is, because like I said, there's still a lot of even sophisticated investors that don't really understand it and how it works and how to use it. And I hope our listeners have now another tool kind of in their toolbox of how the capital stack works and how they might be able to use preferred equity within it. So thanks for joining me today, John.

John Pappalardo (29:24):

Thanks for having me, Ed. I appreciate it.

Ed Aloe (29:30):

I hope today's show inspired you just a little bit and would like to thank my guests again. I'm excited to bring you more episodes with interesting and informative experts to help you navigate your way to wealth in real estate investing.

Credits (29:51):

Thanks for listening to the Real Estate Wealth Podcast. The Real Estate Wealth Podcast is produced by Gusto, A Matter Company. Our producer and audio engineer is Jeanette Harris-Courts with support from Gabe Gerzon and Susan Rangel. Maia Laperle is our writer. For show notes and more information about this podcast, visit edaloe.com. And for more information about CALCAP Advisors visit us at www.CALCAP.com or follow us on Twitter @CALCAPAdvisors.

Ed Aloe (30:27):

I'm your host Ed Aloe, and thank you for listening.