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Don’t Forget About Risk!
July 30, 2020
I recently spoke on a podcast about the fact that retail investors do a poor job of understanding and evaluating risk, often focusing too much on the projected returns of an investment without factoring in risk. Couple this with unrealistic return expectations based on easy returns through a bull market, and now many sponsors only feel comfortable pitching deals to investors if the returns are 18% net IRR or more. To find such returns (or to get even close), one must often pursue higher risk opportunities also inflate the projected returns with overzealous rent growth assumptions, underestimated expenses and capex, and lofty terminal valuations (exit cap rate). Let’s focus on the first piece which is the pushing of the risk envelope.
As mentioned before, retail investors are often blind to risk and therefore assume the better deal is the one with the higher projected return. While we all know this isn’t true, it’s helpful to highlight this idea through a clear example. An investment with a projected IRR of 14% could be a far superior investment compared to an 18% IRR if the majority of the returns are coming from cash flows over a longer hold period rather than banking on a favorable sale in three years. Yet, a casual investor may opt for the 18% IRR deal and not fully recognize the higher risks associated with the 18% return which could quickly drop to a 10% return if something small goes wrong, whereas the similar downside scenario in the cash flowing 14% investment potentially could only be 12%.
An even better way to illustrate the importance of taking risk into account and how lower returns can actually be superior is to compare preferred equity and common equity investments. Preferred equity is a structured investment product that makes an investment in a property’s equity with an attachment point and control rights outlined in the investment’s operating agreement. Preferred equity typically is only subordinate to a senior loan and receives priority distributions as well as a first priority on return of capital. On top of sitting in the senior position in the equity portion of the capital structure, preferred equity also has control rights and remedies, such as management takeover or being able to force a sale, to help ensure the target returns are achieved. The remaining equity, or common equity, invested behind preferred equity in a deal is in a first-loss position and only receives cash flow after the preferred equity’s current yield requirement has been satisfied. With this framework established, it is pretty clear that preferred equity is taking far less risk than common equity in a given deal. In exchange for this reduced risk, the preferred equity tranche receives lower returns than a common equity investment. Furthermore, the common equity that is subordinated in a preferred equity deal should actually demand higher projected returns because it is leveraging a lower cost of capital from the preferred equity. For example, an ordinary deal may show a 16% projected IRR for the equity but if the manager takes on preferred equity at a cost of 14%, then the common equity’s projected return will increase to 19% (but so will the risk). This concept of amplified returns for the common equity and bifurcating the equity of an investment to serve the needs of various investors is the reasoning behind the currently popular “dual-tranche syndication structure”.
As an investor, you have to make a decision about what risk-adjusted return is more preferable: a 12% IRR with preferred equity protection or common equity returns of 17%. If I take our example value-add deal which has a 17% net IRR without any preferred equity involved and increase the stabilization period (months required to raise rents and occupancy) from 18 months to 24 months and increase the exit cap rate from 6% to 6.5%, the net IRR goes down to 8.9%, totally crushing the deal! And these are minor changes to the assumptions; I didn’t even change the pro forma rents or stabilized vacancy loss. As you can see, this particular value-add deal’s returns are sensitive and thus have a wide range of outcomes which can bring less than favorable results for investors. Now, suppose that this deal uses preferred equity financing at a cost of 14% (passive investors in the preferred equity will receive 12%) up to 85% LTV (including capex). This additional leverage brings our base case common equity returns up from 17% to 19.1% IRR to investors. However, leverage magnifies all outcomes, both good and bad. In our downside scenario stressing stabilization time and exit cap rate), the common equity IRR falls to 7.5%. Meanwhile, the preferred equity’s outcome didn’t change at all in the downside scenario because the preferred equity’s “last dollar” basis in the deal is only up to 85% leverage and it has priority distributions. In this particular scenario, I would much rather own the preferred equity tranche and receive a more certain 12% return than take more risk for a chance of a 17%+ return.
Preferred equity’s benefits of offering equity ownership at a lower cost basis than the overall purchase price is the key to its attractiveness and effectiveness, and this is directly counter to LP ownership of common equity in a syndication. A passive investor pays fees to access private real estate opportunities. In a real estate transaction, there are roughly 3% closing costs for both buying and selling. Adding on sponsor fees (2% acquisition fee and 1% disposition fee), the project must sell for at least 109% of the original purchase price just to breakeven. Essentially, LP investors have a basis of 109% of property value while preferred equity typically sits around 85% to 90% of property value. Preferred equity returns, while reaching double-digits, comparable with long-term averages of common equity, are limited in upside; however, the downside is much safer than common, with preferred shareholders breaking even when common equity sees a total loss.