Welcome to The Real Estate Venturist. Every other week, this newsletter will give you a behind-the-scenes look at what it’s like to be a real estate entrepreneur. Here’s what’s in today’s newsletter:

• Bailing out troubled properties

• Bureaucracy—When is it good?

• Buying in bad neighborhoods

• Authentic Mentor

Bailing out troubled properties

Where’s all the distressed apartment deals? I want to buy some.

Unfortunately, owners (and lenders) are finding ways to buy more time. Currently, the in-vogue way to rescue a property is through preferred equity.

Preferred equity (“pref”) inserts a layer of capital between the senior loan (first to be paid) and the common equity (last to be paid). Pref equity is “preferred” over the common equity, meaning it gets paid before the common equity.

Why is pref needed? Because selling a property today is not viable for many owners, primarily because values are down. Today’s 5-6% cap rates are untenable for those who bought deals at 3-4% cap rates. The alternative to pref is usually a total equity wipe out.

I recently saw a multifamily syndicator, who rose to prominence during the COVID boom, announce a new preferred equity fund on LinkedIn:

“We’re launching a 2-year preferred equity fund featuring six of our existing properties in Phoenix. This portfolio investment is designed to provide diversification and higher immediate cash flow to investors and is backed by well-performing assets with a proven track record.”

How can a portfolio be “well-performing” and also need a new layer of rescue capital? Since 2021, rents have skyrocketed in the Phoenix market, and these assets underwent significant capital upgrades. According to their marketing materials, NOI is up 43.7% since acquisition. Objectively, the properties are performing significantly better than they were at the time of purchase.

So why don’t they sell? They can’t or won’t.

Pref is not great for existing investors unless they have no other alternative. The current equity holders get pushed further back in line for repayment. Sponsors (the general partners) know this and usually don’t like to upset their investors—it’s bad for business. I have to assume this sponsor has no other viable option.

While this sponsor is getting ridiculed online by other owners for pitching rescue capital for their own deals, anyone in the same position would do it, too. Plus, controlling the preferred equity piece is preferable to having it be an unrelated third party who won’t prioritize your common equity investors’ interests. We can all argue about the circumstances that got them into this position—paying too high a purchase price, risky debt structure, and a series of other poor financial decisions. Those are all fair game for criticism. But to suggest that an owner should just hand back the keys to the lender and move on is naive. Especially when some syndicators are better fundraisers than real estate owners/operators, raising more money is their primary option.

Bureaucracy—When is it good?

I can’t stand bureaucracy for bureaucracy’s sake.

Yet, we’ve created our own bureaucracy at Calvera. We write a quarterly report for our investors in each fund. In it, we dig deep into our individual properties, fund status, and outlook for the quarter. We also send out a bi-weekly newsletter, the Calvera Insider, to those same investors as well as others interested in Calvera. Lastly, we just held our annual investor meetings last week. We hosted three separate webinars (one for each active fund) where we conducted town hall-style meetings to interact with our investors.

Sometimes bureaucracy is necessary.

As a result, we feel that our investors are well-informed about their investments. The newsletters, reports, and live meetings give them numerous ways to engage with us. We often receive positive feedback for the detail in our materials. It’s good business to have a little bureaucracy.

Buying in bad neighborhoods

When we started Calvera, we had a hard time finding that first deal. After numerous unsuccessful bids on institutional-sized properties, we decided to look for something smaller. I found a 7-unit apartment property in unincorporated San Jose, CA that we purchased for $620k in 2011. We sold it a year later for $900k.

We could write a book about everything that happened in that year. Our property manager was threatened, his car was keyed, the former onsite “manager” destroyed his own unit and blamed us, our contractor grossly overcharged us, we couldn’t get a regular bank loan, we renovated multiple units, completed a ton of deferred maintenance—and sold it for a profit. That was our personal real estate boot camp.

We quickly learned that we weren’t cut out to operate in certain neighborhoods. I think it takes a special person, and I’ve met many who have done quite well in those locations. Unfortunately, like many others, we made our first investment based on price. I knew the broker (young like us at the time), and we thought the neighborhood was “okay.” It wasn’t. A combination of our renovations, rent increases, and an improving market allowed us to exit quickly. Many real estate investors talk about location, but not all stay true to their strengths. When they don’t, their returns suffer.