What Is Preferred Equity?

In a Preferred Equity investment, the preferred investors receive all cash flow or profits once all debts are repaid. They continue to receive payments until they achieve the return. For example, if the agreed amount is 10%, the preferred investor gets the agreed-upon payment until his 10% is covered. This article will elaborate on the pros and cons of preferred equity.

Definition Of Preferred Equity

Preferred Equity, in general, stands apart from Common Equity by affording certain investors, constituting a specific “category of shares,” preferential treatment in the distribution of cash flows. In short, some investors get a preferred return on priority.

In a Preferred Equity investment scenario, the standard practice involves channeling all profits or cash flow to the preferred investors, following the full repayment of the debt, until they receive the agreed-upon “preferred return,”

Investors seeking a balance of higher yield with a consistent return often opt for Preferred Equity. While they may forego the potential for a larger overall return, the appeal lies in a steady cash flow and reduced relative risk. It’s crucial to note that both Common and Preferred Equity signify ownership interests in an entity. Yet, they lack security and direct recourse to the asset, a distinction from the characteristics of Secured Debt.

Preferred Equity In Real Estate

In real estate, preferred equity finds prominent application in commercial projects with high value. It serves as a strategic means to secure additional funding for real estate investments, surpassing the limitations posed by standard investment avenues and conventional bank financing. Positioned within the capital stack, preferred equity plays a pivotal role in facilitating the financial needs of real estate companies undertaking diverse projects.

Investors in preferred equity typically exhibit a preference for a fixed rate of return and possess substantial capital for investment. This characteristic makes it an attractive option for those seeking to diversify their investment portfolio, offering a stable investment option distinct from other ventures associated with higher levels of risk.

Pros and Cons of Investing in Preferred Equity

When considering an investment in preferred equity, it’s crucial to weigh the potential advantages and disadvantages. Here are key points to keep in mind:

How Preferred Equity And Capital Stack Fit Together?

Preferred equity constitutes a crucial component of the real estate capital stack, representing a financing tool employed by developers and sponsors as part of the overall capital raise for specific projects in real estate. Simply put, it holds a subordinate position to debt but ranks senior to all common (or JV) equity. Similar to mezzanine debt, the preferred equity serves as a form of “bridge financing” utilized by operators and sponsors in real estate. The capital secured through preferred equity plays a vital role in bridging the financial gap between a senior loan and the common equity segment within the capital stack.

For individual investors, venturing into preferred equity is a relatively novel option. While preferred equity shares similarities with mezzanine debt in its function, there are nuanced differences in its form. Mezzanine debt operates as bridge financing, leveraging the sponsor’s common equity position as collateral instead of being secured by the underlying property.

In contrast, preferred equity typically holds the right to compel the property sale in the event of no compensation. Additionally, preferred equity often includes an “equity kicker,” providing an extra entitlement to profits if the project performs well— a feature absent in mezzanine debt. In essence, both mezzanine debt and preferred equity offer gap funding, precedence over common equity, and legal remedies for non-payment, but they differ in certain aspects beyond these commonalities.

The Importance Of Preferred Equity In Real Estate

Preferred equity presents a distinctive risk-return profile, blending elements of both common equity and debt. Similar to senior debt, the preferred equity investments enjoy payment priority over common equity investors and have recourse provisions in the event of borrower default. Conversely, resembling common equity, the preferred equity investments typically grant passive investors a share of the upside upon the investment’s exit, although this upside is restricted.

When it comes to preferred equity investments, a robust flat annual rate of return is a common feature, accompanied by the aforementioned “equity kicker” — an opportunity to earn extra in the project’s upside. While exits in preferred equity investments often occur through refinance or partial sale (though not universally), the term is generally shorter than that of an average common equity investment.

As such, investments in real estate through preferred equity appeal to investors seeking predictable annual returns and regular distributions akin to debt investments. These investors are willing to forego some downside protection in exchange for an additional layer of upside potential.

Preferred equity offers distinct advantages for not only investors but also sponsors. Here’s a breakdown of how Preferred Equity backs both investors and sponsors

• For Investors:

Preferred equity presents a secure and stable investment opportunity characterized by a fixed rate of return. If you’re an investor with $100,000 seeking a consistent average return of 7 to 12%, preferred equity could be an attractive option. However, it’s essential to note that the downside lies in the limited upside potential.

Even if the real estate project performs exceptionally well, preferred equity investors receive a predetermined fixed rate of return without a share in the project’s increased returns.

• For Sponsors:

Preferred equity provides sponsors with a more accessible means of raising funds compared to taking on new debt or seeking additional limited partners. While senior lenders and mezzanine loans primarily involve financial institutions and are genuine debt instruments, preferred equity can be sourced from various entities.

Whether it’s a hedge fund, family office, venture capital fund, real estate syndication company, or even a private individual, preferred equity opens doors to a broader range of potential investors. Moreover, it is generally a more cost-effective option than senior debt or introducing another sponsor or manager position.

When it comes to the syndication of real estate, preferred equity emerges as a decisive advantage, offering a flexible avenue for raising funds. Unlike the traditional reliance on lenders and limited partners, preferred equity opens the door to a diverse pool of potential investors seeking opportunities in this space.

For many of these investors, assuming all the risks of a project or backing a loan with a specific asset is not their preferred approach. In this context, preferred equity proves to be an ideal solution — investors receive a stable return, have minimal involvement post-investment, and enjoy a heightened level of security compared to common equity shareholders.

Preferred Equity Vs. Common Equity — Key Differences

Now that we’ve clarified the concept of preferred equity and its functioning let’s delve into the key distinctions between preferred equity and common equity.

• Level of Risk:

The primary and, arguably, the most crucial distinction lies in the risk level. Preferred equity is generally regarded as a higher-risk investment compared to common equity. This heightened risk stems from the fact that holders of preferred equity have less influence over the property and may encounter challenges in recovering their investment in the event of a property sale or liquidation.

• ROI:

Preferred equity commonly provides a higher Return on Investment (ROI) compared to common equity. This stems from the special privileges or preferences granted to preferred equity holders, such as a priority return of capital or an elevated rate of return.

• Liquidity:

Opting for preferred equity investments entails reduced liquidity compared to common equity investments. This implies that selling your stake in the property might pose more challenges if the need arises for investment liquidation.

• Priority on Liquidation or Sale:

When a sale or liquidation occurs, preferred equity holders hold precedence over common equity holders. This signifies that they are more likely to recover their investment before any other category of investor.

• Control:

Investors involved in preferred equity generally wield less control over the property than their counterparts in common equity. This is particularly evident with mezzanine lenders, the predominant type of preferred equity holders, who are typically subordinated to other lenders, including the senior lender or the property’s owner.

Preferred Equity Vs. Mezzanine Debt — Key Differences

Preferred equity and mezzanine debt share a common space in the capital stack, cradled between senior debt and common equity. They generally serve similar purposes by bridging funding gaps and providing additional leverage for real estate projects.

The key distinction between the two lies in their structure. Mezzanine debt typically takes the form of a secured loan with a lien on the property. In contrast, preferred equity represents an equity investment in the entity that owns the property.

In the unfortunate event of a commercial real estate foreclosure, preferred equity investors and mezzanine debt lenders possess distinct ownership rights. Both may incur obligations to senior lenders if foreclosure transpires before the senior debt is fully repaid. However, they share the opportunity to recover their investments over time.

What Are The Downsides And Risks Associated?

Investing in any venture carries inherent risks, and this holds true for various investment avenues like real estate, the stock market, or cryptocurrency. In passive real estate investments, the risk is confined to the capital invested in a particular deal. However, certain investment opportunities offer strategies to mitigate the risk of potential capital loss.

Let’s see some risks and downsides associated with putting your money to work in passive real estate:

• Underperforming Properties

Preferred equity is sometimes utilized to acquire distressed properties, aiming to restore them to their former glory. However, underperforming properties often harbor underlying issues that may pose significant challenges, some of which may be insurmountable. Market conditions might not align with anticipated rental growth, or the operational management might have significantly deteriorated the property, requiring substantial funds for revitalization.

• You are not the Direct Owner

In a preferred equity investment, your ownership isn’t directly tied to the property value. While the inclusion of preferred equity can enhance the asset’s long-term profitability, investors in preferred equity don’t directly participate in the appreciation of the property’s value. Profits in this type of investment are earned through the interest, and even if the property experiences a significant increase in value, investors don’t share in that gain during the final payout.

• Investment is not Liquidated

Capital in a preferred equity investment is illiquid, mirroring the characteristics of most passive real estate investing opportunities we provide. This holds true for various real estate types. If you require your capital to remain liquid or need it to become liquid within a shorter timeframe, such as 5-7 years, real estate might not be the most suitable investment avenue for your needs.

What Are The Advantages Associated?

• You are the First in Line

Receiving payment priority is a significant advantage of your preferred equity investment, determining your position in the capital stack. This positioning ensures that you are the first to receive payments in the deal, minimizing the risk of potential losses and guaranteeing a consistent monthly cash flow.

• Secure

In the event of a sponsor missing a payment or failing to meet the agreed-upon current pay rate (a predetermined portion of the interest rate expected at the deal’s conclusion), you hold the option to assume full ownership of the property potentially. This unique feature provides an additional layer of security for your investment.

• Clear Cashflow Understanding

With preferred equity investing, you have a clear understanding of your cash flow throughout the entire hold period. In traditional passive real estate investments, the preferred return rate might accrue over time or be distributed at a later date, leading to uncertainty in the early years. In contrast, preferred equity ensures a steady and known cash flow amount, distributed monthly instead of quarterly. This reliability makes preferred equity an attractive option for a consistent income stream compared to other forms of passive real estate investments.

• Chance to Partner with Experienced Professionals in Real Estate

The sponsors you collaborate with have a proven track record of successfully concluding deals in other properties that share similar characteristics with any deal they are evaluating. They seek a robust history of success with comparable business plans in analogous markets. These are not operators who are just beginning to acquire and manage commercial real estate assets.

Conclusion

Under real estate financing, preferred equity emerges as a strategic solution, bridging financial gaps for projects. Positioned between senior debt and common equity, it balances risk and reward. This article demystifies preferred equity, elucidating its role, characteristics, and considerations for investors.

Understanding its place in the capital stack is pivotal. Preferred equity not only offers a unique risk-return profile but also plays a vital role in syndication, providing flexibility for sponsors to raise funds. It stands as a distinctive avenue for investors seeking stable returns and sponsors exploring efficient capital options in real estate.

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