Pref Equity vs Traditional Equity explained

Hey, simple, passive cashflow is listeners. Today. We are going to learn the difference between equity and traditional equity. Seen in a lot of deals out there when go through the pros and cons but before we get started, let me show you a little bit. What’s going on the website got we set dates for the year 2022.

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Hey, investors want to go over preferred equity versus traditional equity.

This is in different deals are called different things. A one 82. Or class ABC. But if this is new to you, we’re going to be going over, the story and how we started to implement these options in. Deals. And, maybe stick the end or some advent stuff some more experienced investors. Maybe this is the tool for the job in the certain situation, the first thing. traditional equity was how we first started out. Very simple deals, a straight split, such as a 70, 30 split with 70% of profits going to. Passive investors and 30% going to general partners. And of course that kind of changes based on a better deal or thinner deal. But, it’s very simple, very transparent. And that’s where we started out with this traditional equity. Option. And then we started to realize that, some investors coming in. They may want a more conservative option. They may not want to be in the deal as long as potentially three to seven years. Or even more. And, or maybe they had a lot more money, they were up to that. And gave me a point where they had three to $5 million and they just wanted a straight coupon paid monthly. They don’t really care about growing their money. More.

Also, there are a lot of. Newer investors that maybe came from the private money lending world. Of course, when they see this stuff, they’re like, why the heck would, I want to give up a huge chunk of money to these unsophisticated house flippers it be ordinary income, which we don’t want passive income. We created this pref equity class, which is a very small layer. It’s very small part of the equity. And so this was born. Perfect equity. We’ll just in this case, we’ll call it AWA of course it’s always called a different things and different deals. So always check the PPM. What the naming convention is used. So we started to go in with two different classes of equity, the preferred equity. And it acts like a debt investment. Where you’re getting a straight preference chart. And you’re from like eight, 10%. Maybe I’m at 11% we’ve had in the past and certain deals can cover it.

It acts like a debt investment, like a private money lending deal. But you are an equity investor. The cool thing about that is you’re getting the piece of your, percent per rata share of the cost segregation. Appreciation and losses.

Implications for pref equity. , like I said earlier, this may be a good thing for more mature investors out there who have a higher net worth. We just want to collect a steady income check or newer investors looking to move away from ordinary income to more of the passive income, or just want to try us out. Right way to sit at the top of the capital stack. With a more conservative option where you don’t have to wait. And maybe a couple of quarters for the DOE to get restabilize, to start to see distributions typically with the pref equity or Awan. In this case, you’re going to get paid out a lot quicker. In the past, we started hanging out distributions right after the first complete month. And that paid monthly distributions after that.

Great situation. If you have a skeptic spouse at home, if you guys are looking for the cheat sheet, Working with a skeptic spouse, go to simple passive castle.com/spouse. Also shoot me an email. I got some videos for you guys. That we did at the last. A virtual mastermind. But great way to show about that. My favorite turn a month or two after you. Initially invested in the deal now, nothing. Gives them more confidence than seen. That almost 1% of your investment. Going in the bank account on our routine Buffy basis like that. And hopefully. Gives your skeptic spouse, the confidence that lets you invest some more, which is ultimately what you want to be doing. Cause where else are there are you going to find better returns out there? That’s backed by real estate. And not only any real estate, but stabilized assets with a great business. The bump, the rents up. Another person that makes it’s great for as investors who. Maybe they want to be a hybrid investor. They want the upside. So they’re going to hop in the 82 or traditional equity piece, but they also want some peace of mind. What’s that steady peak. Income stream. Some people will cobble this. They’ll maybe go 50 grand in eight, two and 20 grand or 10 grand or 50 grand in a one. Great way to play on both sides.

Maybe you just want to put in 10 grants. So your skeptic spouse get to see a few dollars hitting the bank account every month, but you have the majority of it is the equity piece, which is ultimately going to grow or, and have a bigger equity, both the poll at the end.

They’re sharing a couple of examples of some people doing this, make it, how to investor , they learn about all this alternative investing information and they had their paid off house and they realize what a mistake that was. So they get a HELOC on it. And now they have access to $400,000. And, they went in a hundred grand into the deal, but they had stale maybe. The remaining $300,000 and they had another a hundred thousand dollars. Liquidity lack around and they had all this cash, right? Like just sitting around doing nothing. What they decided to do is plop down a couple of hundred thousand dollars to 81. Knowing that they would get that money back. Earlier, and that’s how typically it works. What we’re trying to do is like the pref equity kind of gets us off the ground, gets us rolling. But make no mistake. We’re trying to remove those investors as soon as possible. Typically, once we get a lot of the rents, Stabilize. We get the initial bump, maybe in the first few years, we’re trying to do that. Refinance. To get these people out of the games to make all our. Traditional equity, the two guys. Our return squat. Thanks. It’s thanks for helping us. So the guys, now we don’t need you. You guys are out and hopefully it’s like a mutual thing where investors, another reason why they go into the pref equity Awan is they don’t want to be locked up in a deal that long. And I don’t know where that really comes from. Maybe it’s a non-committal thing. Really? Where else are you going to get better returns, but look. Everybody’s got different situations and even people in different situations want to segregate their portfolio a certain way. Maybe you have some part of your portfolio, a little more conservative. You want to take a little bit more asymmetric risk. Which I don’t think these deals are right when you’re investing in stabilize assets that produce cashflow every month with a good business plan. I don’t really call that asymmetric risk, like investing Dodge Clyde or. Altcoins. Out there. Or doing more of a development deal. It would be an example of more.

 

 

 

Another investor asked me one time, what do you think I should do? I’m torn between the two. They both sound right. I asked him the question like, Hey man, how’s your job, ? Do you think you’re going to get fired anytime soon? The company downsized. The reason I asked that as well. If there, if if you’re a government worker or you have a pretty steady W2 job, Is that a ride? If you’ve got your emergency savings account, a few months of expenses, the kind of tie over to find your next job, or you have opportunities to harvest some cash, maybe from a Roth IRA, cash savings, or he locked your good put in traditional equity, especially if you’re under a million or two network, you need to grow your money. Pref equity. 10 11% a great return, personally, I think you can grow it better in a traditional equity. That’s what you should be doing. If you’re not to two to $3 million and above, you’ve got to grow your money. You’ve got to, use that analogy. You got to score more points. You’ve got to put up more points on the board. If not, you’re not going to win the game.

And the flip side of that is say in an investor, said, I worked for oil and gas industry. Things are weird. Or. I’m on a contract work this year. I don’t know what’s going to happen in six months then I would say, you should do the private equity at the stage of the game. Get your money working and get the cash flow. That might be a better way for that particular person to go. But again, it’s different for every situation, every person. Has different, ideally you’re segregating your portfolio as you’ve seen you see my portfolio. Sometimes I take more risks. , most of my portfolio is pretty conservative. Most of these stabilized cashflow deals. And then the last example, some investors, they have a huge glut of , lazy equity. Maybe even half a million or $2 million of lazy equity that they haven’t done. Like I said, I’ve seen investors, invest a million dollars in the first year with me. But I think that’s an outlier, right? I suggest people try things out slowly. Hang out for a year, make sure we’re competent. I know we’re competent, we’ve done a lot of deals thus far, I’m just being empathetic to new people coming in. Because that’s the prudent thing. That’s the thing I would do. I don’t recommend anything that I don’t want to do. At the same time you got money burning a hole in your pocket and for every million dollars of Lacy liquidity you have, you could just stick that into something at 10%, pretty easy. It’s such as HP. I wouldn’t suggest putting all that money. In one place or all that money in a private equity deal. But, you wanted to apply the funds, but you want to do it prudently. A nice way of doing this is putting a chunk in pref equity to just get it working because the idea is you’re going to get that much quicker. A lot of these deals, they make us put a lot of this money is reserves. So once we hit certain milestones, we refinance the money out, we return a lot of that initial Private equity capital to investors right off the bat. And, maybe originally went in with a hundred grand of equity. Maybe you’re only sitting with 50. Grant in a year’s time, not every year, every deal is different. And I want to say any precedents here, but, the pref equity is a shorter term lifespan. If you’re sticking money in there, you got to think that you’re getting a heck of a lot faster than most people on the , traditional equity side. So it can be a strategy thing. The way of thinking about it is you’re putting loading money in, but you’re leapfrogging it to maybe one to three years into the future that you know, you’re going to get it back. Then you go to be deployed into more of a traditional equity, eight to scenario. I do this a lot of times. It’s kinda like a short term, one to three years. Speed in a way, you want to get your money in traditional equity, but you’re waiting for the deals to come around, which, and they’re pretty infrequent. And if you’re starting out, you may not have good deal flow. You’d likely though, right? So you want to be patient, but you still want to get your money working and that’s what the pref equity option. Allows. Just going over, A scenario here, a hundred K investment with a 10, 11% return. Just using that as a. Example. Annual projected cashflow of. Around. 10 to $12,000 a year, right? That’s 10, 11%. I think there’s a typo in this should be $11,000 for 11%. But as it comes out to be on a hundred thousand dollar investment, a little under a thousand dollars. Paid monthly.

Sometimes, people ask, what if we don’t get paid? A lot of times you have to understand that the Private equity is a very small part of the capital stack. In deals pass. The amount of capital we’ve raised in the Avon portion is very small. Like maybe five or 10. At most, maybe we seen 15%. All the capital stack. Sometimes people get concerned like, oh, there’s a investor class ahead of us. There is, but it’s pretty small potatoes in the grand scheme of things. And we wouldn’t put that. One class in there. If we knew we it off and that’s how we as sponsors response speed. Create the allotments for each of these classes and the It may seem like it’s a little arbitrary, some deals are 10%. Some, these are a week take great care. And there’s always a reason why things as So the Awan is a pref preferred rate of return, which starts accumulating once the property. Closes. we’ve had investors as. Does this compound? No, it does not compound. That’s not. That would make things very complicated. In terms of, paying people back. The compound rate. Normally what we try and do, if things are going a little slower, we will. We may start off the payments slower the private equity guys, our full intention is to catch right up the first year to make people whole at that, whatever the 10 At the end. And, I think at this point, like there’s also a question that came up. Hey, once you returned my money back, let’s just say in year two, there’s a refinance where I gave you half of your a hundred grand backs. You’re in the deal with only 50. And the guy asked. Am I still getting my 11% on my a Or on my 50 I was like, only getting money at your 50 minutes.. I wish if I, if that was the case, I’ve invested that too, but no, you only get money that you’re making in the pref equity on what you have in the deal. Again, our intention is. You out. So our traditional equity investor returns can’t And again, like I said earlier, you’re still an equity investor, even though it acts like a that you have equity, which means, yay. You have the tax benefits and you get your pro-rata share of the The cool thing. And I said this a lot as a little trick or hack I’ve had some syndicators invest in our deal, kind of shows. other people like to invest with us. And when this stuff was all new, there was another syndicator that actually took a big chunk of my pref equity investment. And I was like, are you doing? Talk to the logic. And they told me that, we liked the fact that we can. the money in and get our share of the losses and then get out of the deal sooner than everybody else. But we get out, our CB has told us that we get to retain hold onto those losses until the whole deal exits. So let’s just say. We refinance every, all the pref equity guys out in year three will all that depreciation recapture. Capital gains. They don’t have to pay that. Until the whole deal exits potentially another few years later, or maybe even another five years after that. It’s a great way of kind of stock piling, passive activity losses. If you’re somebody who runs low on that.

Yeah, you will get a one, we’ll get the full benefit of the cost. Based on your pro-rata share of the capital stack.

And said in a different way, one are entitled to the losses. But their original principal. But of course consult your CPA. A tax professional. Here, just getting more into the advance. Aspects of the pref equity. Some people are like, Haley and I trust you. Should I do pref equity on this one or traditional equity? And again, every situation is different and in everybody’s portfolio, you have different applications, and that’s just based on your personal preference. But, this particular individual, I know their portfolio pretty well. They trust me and I know what they’re trying to do. Long term. And in this particular case, there was not a yield deal was more of a medium to heavy value. Add. So there was a lot of upside in that way. And as this says right here, It is less advantageous to do pref equity when your upside is higher. Because you’re giving it up. To use an analogy. It’s kinda LeBron James signing with Adidas, obviously that didn’t happen. And obviously Adidas gave LeBron James a low-ball offer or a much. Lower offer than Nike. In a way. I don’t want to take my 10, 11% straight preferred return even though that’s great. I think this one’s a good one. It’s going to pop. And therefore I wanted to go into the traditional equity. If you want to have a part of your portfolio where you just get a straight 11%, 10% return. You’ve got your deductions, your passive activity losses coming from it. You want to have a part of their portfolio? What I would look for are the more yield deals. As opposed to the more value add type of opportunities with the upside. Now you might have the complete opposite viewpoint at this. And you’re like, the ones with the more value add, those could potentially be more risky. I don’t necessarily agree with that logic, but Hey, that’s you guys, right? You guys can think whatever you guys want. That person may think. If in a more riskier project perceived risks, even though it is real sand stabilize after all, if people need a place to live. They may want to go for the private equity side. It’s just, I’m just giving you guys ideas out here.

So instead in a different way might be more appealing with the 82 and the 81 does not have a large gap.

And said in another way. The more the yield deal. The better candidate. It is for pref. Equity, whereas the more value add the more pop. The potential pop. There could be, It makes I would do the private equity less. But then again, it’s just timing, right? When deals pop up, you don’t really like. And you want pref equity, you feel like that I’d like to have a little more stable cashflow on a month to month basis and the next step comes up and it’s a value add, you got to get what you need, that’s life. I don’t know. A lot of these deals, you can’t really go wrong. Pref equity, eight one. One B2, just kind of personal preference. Digging in here more, since those stuff is the same stuff we’ve been talking about. Difference between private equity and traditional equity. Again, 82 has, or the traditional equity. Has the higher potential returns and one could say, if you’re not getting the upside, why are you playing the game? Maybe like they said, if you got four or $5 million, you don’t care. Already at end game. But, for most people under a couple of million dollars net worth. You got to play the game. And you got to put your money in traditional equity because you need the girl. While we’re on this topic, people are like, I went into the V deals at the minimum. Why am I not to financial freedom? Do you only put in $150,000, $150,000, even if you made 15, 20%, it’s not that much money. You got to put in more money. You gotta do more skin in the game. A lot of these, like what people don’t realize is, most sophisticated investors are putting in maybe 50, a hundred thousand dollars, but they’re going in a lot of deals. They’ve got a big chunk of money and they’re working. And the nice part of that is it’s 82 investors than traditional equity investor to turn to equity for life. Whereas, and in this case it was a 70, 30 split. Whereas the eight. One investors are exited early and do not get the upside. We said this before. This is just saying it in a different way. Equity investors are chipped off the bus, kicked off the boat or whatever vehicle you want to use. We’re basically using them. And we’re paying them for their services of their money. But once we get the money, we’re kicking them off because their equity. They get their passive losses. But they are not entitled to the upside. They just get a straight return. And that is the downside of A1C. The website, you’re just getting your street, maybe 10 or 11%.

 

Or pref equity or move earlier. A lot quicker than eight to investors where the eight two investors typically stage. To the area and at least how I do it. Again, always check your PPM, right? Cause there are deals out there where even a two investors are debuted it out. I don’t think that’s fair. But I’ve seen deals out there where people do that. 82 has a slightly, above break, even point in terms of. Occupancy of gala and whatnot. Gets 12% let’s just say the deal struggles. Technically the A1C guys are going to get people first. But if the one’s at eight tunes, aren’t getting paid. You know that the break even point on all of these deals pretty. Pretty low. Most of the time the deals go stabilize above 90%. No problem. And sometimes even in really hard times, it goes up to 80%. But a lot of these deals, you start to lose money. Again, it ranges, but anywhere from 50 to 70%. The typical program. It’s going to take a lot. For a one and. Traditional and private equity to not get their distributions. Sometimes, of course we always fall back. Because it’s the responsible thing to do. It’s not like we don’t have the money. Losing money. But we always want to be conservative and protect the asset.

This is, a good example is like when we had COVID right. There were a lot of more terms of fictions. There was a lot of insurgencies, a lot of times we held back distributions. On investors, but we still paid out the 81 for the most part. You’ve been through COVID.

Something that we’re working through now and probably after the year 2022. So probably be an afterthought. Nobody will ever think about this again, but. During COVID, a lot of the lenders froze up. For good reason, right? This country has never been through anything like this and it’s unprecedented. When things are uncertain, What banks usually do is they get lot more conservative. And they require a lot of these, what I call COVID reserves a huge chunk of money , I’ve seen it in our deals and you’re from like a couple hundred thousand dollars to $600,000. That they want us to stick in the back. Now the pref equity came in. Great for the situation because the deal with the lender that we had, that’s written into documents is. Once we hit certain metrics or in a couple of quarters into the deal. They are too. Re release these covert reserves and we are going to get it back. And that’s where we like to exit out these private equity investors. It’s great for these situations. And I’ve used this, sane in the past. Pref equity makes good deals better because it allows us the timer, leverage and our debt. By taking on that little, extra debt in the beading. Yes. For paying a little bit higher rate for it. We’re able to time it out at the right exact time. And us to shed that debt. And give most of the returns, the traditional equity investors at that point. And, but the flip side is like in bad deals, pref equity makes it worse. I’ve used this same. Terminology and same verbiage in terms of bridge loans. Using the right situation, bridge loans are the perfect usage of debt. And, it allows you to be very flexible or prepayment penalties and allows you to get the rehabs done. And, Reposition the asset. But in bad deals, it can be very risky. And that’s why sometimes the use of long-term agency financing with big prepayment penalties may make sense. I think this is what’s hard for most passive investors you’re looking for general rules of thumb and there is none. It’s never a case of bridge debt versus agency debt is best. It’s never the case that using a little bit of private equity, in the capital stack is good. It’s hard to tell if you’re a passive investor. But just know that it’s not always, oh, if they’re doing this type of thing, it’s always bad. It’s always on a case by case basis.

But yeah, that’s sorta how that these Clover reserves are working. And , I anticipate after the year 2021, we won’t really be talking about these types of things. There’ll be something else that pops up. I’m sure. We get these coal reserves back based on occupancy levels, relationships with the lender and could range anywhere from six to 12 months. A lot of investors have they’re asking oh, When you think you’re going to get a good chunk of the pref equity back or my investment back, cause I want to kind of time things and I’m like, here’s the situation, right? And we don’t know, it’s unprecedented, nobody’s had their COVID or reserves or these yet. Nobody has gone through a pandemic and had to go to these lenders restrictions or terms. And, so we don’t know, we just know what kind of, what the deal was with the banks, which was based on occupancy levels, good relationship, and six to 12 months. But, as anything. In investing there is risk. You could be in there longer. But. Accumulating your breath, right? Money is good. And that’s the nice thing about being a. Pref equity investor. But yeah, hopefully this helped out guys as a pref equity, traditional equity one oh one. If you guys got any questions, please let me know.

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