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Leveraged Breakdowns

Preferred Note Case Study, Part One: The Question


This real estate investment case study will challenge your ability to model capital structure and a returns waterfall. With practice, you should be able to complete this category of case study within 30-45 minutes. This post will introduce you to the question and go over some key terminology. At the end, we’ll challenge you to attempt this case study and post your result in the case study forum before we follow up next week with our solution.

Preferred Note Case Study Question

The proposed real estate investment case study begins with purchasing an office building for $100. This office building will throw off $8 of NOI in year 1, growing thereafter at 3% per annum. You intend to sell this building in seven years at the same cap rate you went in at. You will fund this transaction with 4.0% fixed debt at a 50% LTV, a preferred note to 75% LTV, and you’ll fund the remaining common equity. These are the terms of the preferred note:

  • Face Value: $25
  • Coupon: 8.0% Cash and/or PIK
  • Additional Cash Flow Participation: Proportional split of distributions after common equity coupon of 6.0%
  • Exit Participation: 40% share of exit / capital profit after preferred and common are reimbursed for their initial commitments

What expected return on the preferred note will you market to investors?

Details of the Preferred Note

Preferred equity sits between debt and equity. If you had a mezz piece, the mezz would be under the preferred and above the senior debt. But for simplicity’s sake, let’s ignore mezz and skip straight to the preferred. A preferred note can really be structured any way you like, so long as you can raise capital for it. In this case, I’ve thrown in a few layers to make our waterfall a bit complex.

The Prefered Waterfall

This real estate private equity case study is really just asking you to design a waterfall. With that in mind, here are a few key terms to understand before we begin modeling:

  • Face Value is just the preferred note’s principal balance. Since we said the note will cover the capital stack from 50% to 75%, and we’re buying for $100, that implies a $25 face value.
  • Coupon: The 8.0% coupon means the investors will receive $8 every year, if it were all cash. However, if NOI after debt service was only able to cover a portion of the $8 coupon, the remaining balance would PIK (payment-in-kind) into the balance. So if you can’t pay any of the $8 coupon, then your balance would increase to $108 and the next year you’d owe $108*8.0% = $8.64. And so forth, with preference to cash payment but PIK if necessary. PIK just guarantees that the investor will achieve at least an 8.0% IRR since the interest compounds into itself.
  • Additional Cash Flow Participation: After the preferred gets its 8.0% cash or PIK coupon, the common equity is entitled to a 6.0% coupon itself. But after that common coupon, the remaining proceeds would be split proportionally between the preferred and the common.
  • Exit Participation: You sometimes see this with preferred equity. So after both the preferred and the common get their principal and any PIK back, they will split the proceeds 40/60 in the favor of the common. This 40/60 completely ignores the initial equity split, which is 50/50.

Would you ace this interview?

If you were to receive this real estate private equity case study today, would you be prepared? If you think you have the answer, post it in our case study forum. We will follow up next week with our solution and a detailed walk-through!

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