Banks and financial institutions are increasingly tightening lending requirements amid high interest rates. As a result, real estate companies are turning to creative financing to continue developing commercial real estate.
Preferred equity fills the gap between senior debt and common equity as loan financing for projects shrinks. Preferred equity can keep commercial real estate projects moving that otherwise might have fallen short of the capital funding needed to get off the ground.
How Does Preferred Equity Work?
Purchasing and building commercial real estate requires significant capital, and market conditions can sometimes make it challenging for companies to raise the needed funds. The capital that funds a project is referred to as the capital stack. When debt financing dries up, companies can turn to preferred equity to fill the gap.
Preferred equity sits behind senior debt for payments but ahead of common equity, which is where the “preferred” aspect comes from. Preferred equity can share debt and equity characteristics, helping a project strike a balance between risk and reward.
Equity investors are the last to be paid back in the capital stack, and senior debt holders are the first. In between, two forms of financing can share debt and equity characteristics: a mezzanine loan and preferred equity.
Though the two may offer investors similar rates of return and serve to bridge the financing gap, they are different. The mezzanine loan is debt, although junior to a senior loan for payments. The underlying real estate asset doesn’t secure it. However, a mezzanine loan may come with equity warrants, entitling the holder to a percentage stake in the venture if it performs well.
How Is Preferred Equity Used in Real Estate?
Preferred equity can be crucial in a challenging commercial real estate market. Ventures looking to fund large-scale projects may need to bridge a gap in their financing, and preferred equity has become a popular choice.
Preferred equity has existed in real estate for years, but its usage has increased recently. Preferred equity is often used in three ways:
- Existing mezzanine loan: Additional equity needed to complete the project.
- No desire for a mezzanine loan: Debt providers may eschew a mezzanine loan.
- Reduce sponsor’s equity: Ventures looking to increase liquidity.
With preferred equity, an investor may get limited voting rights in the venture but receive a set rate of return regardless of how the property performs. Additionally, their returns are higher than those of debt holders, though lower than those of common equity investors.
Pros of Investing in Preferred Equity Real Estate
Buying into a preferred equity position in a commercial real estate venture can provide attractive advantages to investors. As a preferred equity investor, you get certain privileges or preferences, in exchange for your investment, including the following:
- Higher return on investment (ROI) than common equity
- Payment date, regardless of the project’s performance
- Potential downside protection if property foreclosed
- Priority over common equity investor if the venture is liquidated
Cons of Investing in Preferred Equity Real Estate
As in any investing, where there are pros, there are also cons. Preferred equity in real estate is no different. While preferred equity investors may enjoy certain privileges, they also have these disadvantages to contend with:
- Higher risks than common equity investors
- Less control of the property than other investors
- Harder to sell stakes in a venture than common equity
In the capital stack, preferred equity investors are better positioned to deal with adverse market conditions than common equity investors. If the project goes south, preferred equity investors get paid before common equity investors.
Is It Safe to Invest in Preferred Equity Real Estate?
Preferred equity investments can be attractive because of the risk-reward scenario. How comfortable you feel with the advantages and disadvantages can depend on your investment goals. For instance, are you looking for income without much concern about upside participation in the project?
Your equity position in the venture offers no control over day-to-day decision-making and may provide for limited voting rights. As a preferred equity investor, you can also lose everything.
You are superior to common equity holders for repayment, mitigating some risk. However, you could lose all if the property is liquidated at a price below your investment. Here are key considerations for assessing the safety of preferred equity investments:
- Relative position in the capital stack
- Order of repayment at foreclosure
- Condition and attributes of the underlying property
- Trust in the venture’s sponsor
- Sponsor’s track record
Your comfort with a deal could also lie in how well you negotiate the preferred equity structure of your investment. For instance, it might be possible to structure your investment so that you also receive some of the upside of a property’s value increase, something that isn’t always offered to preferred equity investors.
Preferred Equity vs. Common Equity
The biggest difference between preferred equity and common equity is the position in the capital stack. If you have a preferred equity position, it’s safer, meaning it is ahead of common equity, so you can recoup your investment if the venture fails.
Common equity is the equity tranche, the first line of defense to absorb any losses from the investment. However, its position below preferred equity means it has a higher risk. Therefore, there’s a chance you'll experience higher potential returns.
Besides being positioned for more profitable returns, common equity participates fully in any upside to property appreciation. Preferred equity does not participate in the upside unless negotiated into its deal structure.
Understanding the differences between preferred equity and common equity is crucial. Doing so can help you decide which type of investment aligns with your investment strategy.
Keep Real Estate Ventures Alive
As a preferred equity investor, you have the potential to keep a commercial real estate venture alive while it’s looking for gap funding. Especially in the current high-interest rate environment, commercial real estate projects might find obtaining debt financing challenging. Alternatively, sponsors may want to reduce their common equity exposure.
Placing yourself in the middle of the capital stack with a preferred equity position can offer you the privilege of being paid ahead of common equity investors. While your preferred equity investment may not provide much say in the property, you can receive income and limited downside.
Frequently Asked Questions
Is preferred equity a loan?
Preferred equity is not a loan. It’s an investment at a negotiated level that gives an investor proportional ownership or the right to ownership if the real estate company defaults.
What is the difference between preferred equity and bonds?
Preferred equity functions mostly like stocks. Unlike bonds, which mature, preferred equity is perpetual. While both may have set payment dates, preferred equity investors receive dividends instead of bond investors’ interest.
How is preferred equity paid back?
Preferred equity is paid back after debt equity investors but before common equity investors. It can be paid by a set date from cash flow or as an accrued amount at a future date.
