Is an 8 percent pref on a 55-plus private placement really just a note?

Question

Take a private placement on a 132-unit active adult community where the sponsor is raising $9m of what the deck calls preferred equity: an 8% pref, then a 70/30 split after a 14% IRR hurdle, on a five to seven year hold. Here is the question worth working through. 8% sounds like an interest rate, and the deck says the pref accrues if it is not paid in cash. That reads like a loan. But the same page says the investor is a limited partner whose capital sits behind the bank. If the 8% is not guaranteed and the investor is behind the lender, what makes it a pref rather than equity with a nicer number on the cover?

ehernandez74 · Answer

The word pref is doing less work than it appears to. It means your 8 percent gets paid out of available cash before the sponsor takes anything, and if there is no cash there is no payment. A note would give you an enforceable payment obligation and a maturity date, and usually collateral behind it. Ask whether the 8 percent is cumulative and compounding, because unpaid and never caught up is a very different instrument from unpaid and accruing at 8 on 8.

renee_dubois · Answer

Also ask where the cash for the pref comes from in year one. A stabilized 55 plus community might throw off enough, but if any part of the raise is funding lease-up or a repositioning, distributions get paid from reserves for a while, which is your own money coming back to you with the word yield attached.

hannah_west29 · Answer

The number to get before anything else is the debt service coverage at going-in occupancy rather than stabilized. On active adult at that size, if the bank loan eats coverage down to 1.15 in year one, the 8% pref is decoration until year three, and the 14% hurdle ends up being the sponsor's problem too. Read the waterfall for whether accrued pref is paid before or after return of capital at sale, because that ordering is worth more than the coupon. And have your own attorney read the LPA. Whatever the deck summarizes, the agreement governs.

Is an 8 percent pref on a 55-plus private placement really just a note?

3 replies