Hi {{first_name | there}},
Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.
In August 2023, one of our funds invested $5 million of preferred equity in a 14-property workforce housing portfolio in New Jersey.
The initial term was eight months.
Final payoff came 26 months later (October 2025).
Despite the delay, the investment beat the original pro forma and generated a 22.9% IRR and a 1.39x equity multiple net to our fund.
Here's how the structure helped us navigate the delays, what we got right, and what I think we got wrong.
The Structure
Preferred equity sits ahead of common equity and behind the senior debt in a real estate deal. Here's what we negotiated for this deal:
15% annual current pay, reserved up front. Instead of relying on monthly property cash flow, we collected this at closing and held it in an interest-bearing account.
A ~2.4% origination fee at closing.
Roughly 20% of the capital stack in common equity beneath us, all of it the operator's own money. They had no outside investors in the deal, making it unlikely the operator would simply walk away from this portfolio.
Forced-sale rights, meaning we could compel a sale ahead of a senior lender foreclosure if things deteriorated.
A 24% default rate that applied if they went past the maturity date.
Personal guarantees from the principals. Potentially helpful, although enforcing them can be expensive and time-consuming.
Why Would Anyone Pay That?
This question must be asked anytime an operator accepts expensive capital. The assumption is usually distress.
In this case, it wasn't. This operator was wealthy, had a large real estate portfolio, and owned their own construction company. Like many developers, they didn't have idle cash, because they were running multiple developments at once and wanted to keep liquidity available for loan guarantor requirements.
They were buying speed and certainty. Our $5 million funded parts of their highly profitable development projects, aided by significant tax abatements.
What Actually Happened
They didn't pay us back on schedule.
The plan at maturity was a recapitalization with a new investor. That process took longer than they said it would...then it took longer again.
The operator repeatedly overpromised on timing and underdelivered. Some things were outside their control, but they had an agreement with us.
We agreed to a 12-month extension in May 2024 with an extra 4% fee. They paid off some principal before final maturity; after that, the 24% default rate applied to the rest.
We also had to decide whether to enforce our remedies. We had the right to force a sale of the collateral. We chose not to.
The reasoning was practical. Liquidating fourteen (or even one or two) multifamily buildings is a slow process, and we believed letting the operator raise capital to recapitalize us would pay our investors faster than a forced sale would.
Ultimately, a debt fund that worked closely with the operator purchased our remaining preferred equity interest. That exit path wasn't in our original plan, but having multiple potential exit strategies is essential.
The Numbers*
Net to our fund, over a ~2.2-year hold:
22.9% IRR
1.39x equity multiple
17.9% average annual return
A few weeks ago I wrote about why a single return figure (like IRR) tells you almost nothing. This deal is a good illustration.
At investment committee, we projected a 21.88% IRR and a 1.13x multiple over eight months. The deal took three times longer than that, and the IRR still came in slightly above projection while the multiple came in far higher due to longer hold time and the default rate at the end.
The Uncomfortable Part
We got the structure and property selection right, but looking back, we overestimated the operator's quality.
The operator was cooperative throughout the process, even as we pushed for repayment. But he repeatedly gave us timelines he couldn't meet (some delays were outside his control).
Our original 2023 deal memo stated there was "no notable operator risk beyond the risk of fraud."
We were wrong.
There was real operator risk. It wasn't fraud. It was weaker-than-expected execution and a management team whose depth, systems, and processes weren't as strong as we had believed.
This operator would likely not pass our due diligence process today.
Fortunately, the upfront current-pay reserve protected our income during the original term, and our contractual rights gave us leverage as we pushed for repayment.
One thing we've changed since 2023 is how thoroughly we investigate an operator's liquidity, broader portfolio, management team, and internal systems and processes.
We've learned not to let a strong legal structure compensate for weaknesses in the operator.
Questions Worth Asking
Whether you’re investing directly in real estate or passively alongside an operator, I’d ask three questions:
What has to go right for this investment to work, and what happens if it doesn’t?
Where will the cash come from along the way and at exit, and what happens if it takes longer than planned? Our exit here came from a source that wasn’t on our original list of five.
Who is responsible for executing the plan, and what evidence do I have that they can deliver?
If you have feedback, if there's something you're learning about CRE, or if there's a topic you'd like me to cover in a future newsletter, reply to this email. I read every response!
All the best,
Ben Kahle
Managing Partner | Wellings Capital