Providers of preferred equity must diligently assess and analyze two major components of a development project to successfully and repeatedly achieve above market returns.
The first assessment is probably the most obvious – a preferred equity investor must allocate capital only to projects that hold a competitive advantage to the rest of the market. Development projects must provide all investors and lenders with returns commensurate with each party’s respective risks. So, a preferred equity partner must accurately gauge and assess all elements of project risk before issuing any proposed deal terms to the sponsor developer. This preliminary project evaluation includes any and all metrics provided by the Sponsor, including development plans, market research, debt structure, entitlement hurdles, marketing plans, and detailed financial projections for each phase of the development project.
While it would be prudent for a preferred equity partner to thoroughly research and verify all project and market data provided by the developer, the developer might not directly provide the second key element to successful preferred equity placement. This second key factor is research and due diligence on the sponsor developer. Whether the sponsor developer is an individual or an established organization, a preferred equity partner must realize that an investment’s successes or failures ultimately lie with the effectiveness and productivity of the developer. There is more to underwriting a developer than a simple assessment of competency. Before considering the issuance of a term sheet, a diligent preferred equity partner must assess and investigate the Sponsor’s past development experience, current financial position, historical business conduct, personal attitudes, corporate cultures, and shared project vision.
Perhaps the most important element for a preferred equity partner to remember is that any venture is truly and utterly a partnership. No matter how secure a project presents on paper, it is ultimately up to its partner to execute the presented development plan. Without the right development partner, even the best laid out development plan will not return the contemplated financial rewards. Given a preferred equity firm’s position in the capital stack, it is critical that a level of competence and performance is investigated and established before jumping into a large-scale partnership.