How to Underwrite Preferred Equity Investments

Underwriting is the process of collecting and organizing the financial information needed to build a projection of income, expenses, and investment returns (a pro forma). These projections guide investment decisions related to purchase, refinance, and sale. For a deep dive on underwriting, check out my book, The Definitive Guide to Underwriting Multifamily Acquisitions, which is available on Amazon. In this book, I walk through the financial model we use every day at Lone Star Capital and show you exactly how we derive every single input and assumption for a multifamily acquisition. If you’d like access to our internal underwriting Excel model, head to www.robbeardsley.me for your free download.

Preferred equity is a unique investment strategy which has the some of the benefits of both debt and equity in order to provide favorable risk-adjusted returns. Read this article to understand the basics of preferred equity. The process of underwriting a preferred equity investment is very similar to an acquisition but the metrics of focus are slightly different. We maintain our same conservative underwriting standards when we underwrite a preferred equity investment, but instead of focusing on the prospective return, we focus on appropriately sizing and pricing our preferred equity investment while closely monitoring downside protection metrics. Sizing refers to determining the amount of preferred equity we are willing to invest in the project, which can be the most important factor for a deal since it establishes the basis of protection for the investment through equity cushion. For example, we are typically only willing to invest up to 85% of the project’s cost in a preferred equity position, which implies there is 15% of equity cushion subordinate to our investment. However, we can’t just simply size the investment based on a percentage of project cost alone, or else we could get into trouble. 

A big focus to ensure appropriate sizing of the preferred equity investment is a debt service coverage ratio (DSCR). DSCR refers to the ability of the property’s net operating income (NOI) to cover amortized debt service (regardless of whether the actual payments are interest-only or not). Senior lenders providing permanent financing are typically looking for a 1.25x DSCR or better. However, in the context of preferred equity, DSCR refers to NOI divided by the senior loan’s amortized debt service plus the preferred equity’s current pay component. While preferred equity lenders are often more flexible than senior lenders, preferred equity is typically looking for a 1.05x cover. If the deal doesn’t support this level of DSCR then the preferred equity has the option to reduce its investment amount which will lower the current pay burden on the property, or it can reduce the current pay percentage (for example from 9% for 6%). However, a savvy preferred equity investor is going to disproportionately raise the accrual component of the preferred equity to compensate for a lower current pay since they are effectively taking more risk by postponing more of their return to the back-end capital event, whether it be a refinance or a sale. In practice, we evaluate both the pref DSCR, as defined above, as well as a simple interest coverage ratio (ICR) which is based on the actual senior loan payment and preferred equity payment, which may or may not be amortizing.

The next area of focus in terms of appropriately sizing a preferred equity investment is a term called “last dollar basis”. Last dollar basis refers to the preferred equity’s total capitalization either in dollar terms or as a percentage of the cost or value of the project. For example, if a property has a senior loan of $7,000,000 and a preferred equity slice of $1,000,000 then the preferred equity’s last dollar basis is $8,000,000, since the preferred equity’s $1,000,000 sits subordinate to the senior lender’s $7,000,000. Additionally, if the value of the property is $10,000,000, then the last dollar basis could also be considered 80%. We track multiple last dollar basis metrics throughout the investment pro forma as we want to ensure we have sufficient equity cushion. Most importantly, the deal should project substantial equity cushion upon completion of the business plan so that the preferred equity investment can be paid off via a refinance. Since senior lenders are typically only able to lend up to 75 or 80% of value, the preferred equity’s last dollar needs to end up around 75 to 80% in order to be paid off fully by a new loan. Otherwise, the partnership will need to sell the property or recapitalize a portion of the equity in order to pay off the preferred equity. Keep in mind, the more sophisticated approach to calculating last dollar basis is to include the accrual portion of the preferred equity’s return. For example, a $1,000,000 preferred equity position which has a 6% accrual rate should tack on an additional $60,000 to its basis every year due to the accrual. If the accrual is not considered, you could be in for a rude awakening if you’ve accumulated a substantial accrued return over many years and come to find that your true basis in the deal is much higher than you are comfortable with. This is one of the reasons why preferred equity is generally more suitable for shorter hold periods, such as 18 to 36 months. 

Lastly, a bonus metric which can provide further insight or color into the downside protection of a preferred equity investment is the breakeven occupancy, or the occupancy rate needed to maintain enough cash flow to pay the preferred equity’s cash yield in full. This varies by deal and business plan but obviously the lower the better. For deals with very strong breakeven occupancy, a higher current pay can be supported, which could afford the preferred equity provider to offer a discount on the accrual rate, resulting in a lower all in rate. The focus of our preferred equity investment strategy is to be flexible in order to meet the needs of the sponsor/owner. Below is a screenshot of the pro forma in the preferred equity module from our underwriting model. If you’d like to get a copy of this underwriting model, you can do so by heading to www.robbeardsley.me. 

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As you can see, we track last dollar basis from Year 0, or “going-in”, as well as through a 3-year pro forma. An interesting point to note is the fact that the last dollar basis is greater in Year 1 versus Year 0. This is because we are taking the accrual component of the preferred equity’s return into account in the last dollar basis to emphasize the increase in capital needed to fully pay off the preferred equity tranche, inclusive of its full return.

Another metric we focus on is the preferred equity’s debt yield. Debt yield typically refers to net operating income divided by the senior loan amount. However, since we are focused here on our preferred equity investment, we calculate debt yield by dividing NOI by the senior loan amount plus our preferred equity amount. This effectively represents the cap rate at which we would own the property if we owned the deal at our last dollar basis. While this is not really possible, it is another good indicator to better understand the deal.

To recap, the purpose of underwriting preferred equity investments is to qualify the merit of the investment generally via our standard underwriting practices and to appropriately size and price the preferred equity investment based on the deal profile and risks. If you’re interested in learning more about preferred equity investment opportunities, please reach out to me directly.