The commercial real estate industry today is highly competitive. Commercial owners are chomping at the bit to acquire deals, and bring their investors strong returns.
Unfortunately, Covid-19 has brought uncertainty to commercial lenders and as a result, has created a gap in the capital stack.
Preferred equity in real estate is a part of the capital stack that allows owners to increase their leverage, while simultaneously providing individual investors access to a secure source of passive income.
This article will walk you through how preferred equity is used in real estate and the solution it provides to sponsors and individual real estate investors alike.
What Is Preferred Equity?
If you are confused about preferred equity, don’t worry. While it might seem like a complicated term to wrap your head around, it is a simple investment vehicle to understand.
Preferred equity financing occurs when a large amount of capital is needed for a commercial real estate project.
Typically, when large banks are unable to provide the necessary investment to acquire the asset, additional funds are received from preferred equity investors that will sit on top of the primary debt within the capital stack. Preferred equity investors will receive preferred rates of return that hold priority over other payments except for senior lenders.
Preferred equity is commonly opted for in large commercial real estate projects above $10 million.
Multifamily preferred equity is preferred equity funding for multifamily real estate deals.
Preferred equity financing helps sponsors reduce their capital requirement while providing investors a preferred return from their contribution to the project!
Unlike common equity, preferred equity investors will have rights that no other investor in the project has.
In the current economic climate, you will find that preferred equity holds an attractive position as an investment through the fixed rate of returns it offers investors during unsteady times.
Preferred Equity VS Mezzanine Debt
Another way to understand preferred equity is through examining it in comparison with mezzanine financing.
Mezzanine debt acts as a gap financing for a deal that comes as a loan from a lender. When it comes to preferred equity, it also works as a gap financing but is provided as capital from investors.
When it comes to mezzanine financing, a lender will require interest and amortization with terms set in place on the loan.
As for preferred equity, investors will expect a preferred rate of return on their capital, and terms will be outlined in the projects operating agreement.
The benefit of preferred equity is it provides access for individual investors to contribute to a lucrative investment fund and receive the preferred rate of returns on their invested capital!
Preferred vs. Common Equity
Preferred equity real estate investors will secure a stable preferred rate of return of their capital. This return will be outlined in the operating agreement, along with any additional authority preferred equity investors will hold within the project.
Preferred equity returns will be prioritized right under the senior debt and will have superiority over common equity investors’ distributions.
In the case of common equity, common equity investors will not receive fixed returns rather a share of the overall ownership in the project that can fluctuate based on the success of the real estate project. Common equity is in most cases risker than preferred equity but can result in higher capital returns.
Examples of Preferred Equity in Real Estate
There is a multitude of preferred equity real estate examples available for you to make use of. Through these, you will be able to understand the concepts of preferred equity to analyze if it would be the right investment vehicle for your capital.
For example, imagine a real estate syndication company is looking to acquire a multifamily property that carries an estimated price of $30 million.
The senior lender is only willing to lend 70% loan-to-value making the equity requirement for the real estate project, $9,000,000 million.
If preferred equity investors have committed to investing 85% loan-to-value, this will reduce the capital requirement by $4,500,000 and would provide 15% preferred equity into the capital stack.
In exchange for providing the $4,500,000, preferred equity investors will receive a 10% preferred rate of return. This preferred equity will be a priority of payment right below the primary debt from the senior lender.
Benefits of Preferred Equity in Real Estate
When it comes to multifamily preferred equity, you will find that it comes with a range of benefits for the investors. Let’s take a look at the primary benefits of preferred equity real estate investing.
Predictable Annual Returns
One of the prominent reasons why investors find preferred equity attractive is the secure passive income returns they provide. Investors will see 7-12% stable returns on their investment.
Priority Of Payment
As a preferred equity investor, you are entitled to payment before the dividend for common equity shareholders is distributed. Additionally, preferred equity investors are given additional rights and authority than common equity investors. For example, if there is any default on the payment, preferred equity may have the right to take control of the management of the property depending on the terms outlined within the operating agreement.
Hybrid Risk/Return Profile
A preferred equity investor gets to enjoy a hybrid risk and return profile. As mentioned above, similar to senior debt, preferred equity investors get paid as a priority over the common equity shareholder. Along with this, there are provisions placed for the investor in case of any default on payment.
On the other hand, there is also access to upside potential, which makes common equity investing so powerful. As a preferred equity investor, you get to avail yourself some share of the upside once you exit the deal. The only difference is that the upside is typically capped for preferred equity investments.
By investing in preferred equity, you get to ensure that you are able to avail of the opportunity of diversifying your investments. Many times, investors feel constricted because of the liquidity risks that prevail in their portfolios. Through preferred equity, you get to mitigate your liquidity risk as you diversify your portfolio.
Now, your portfolio showcases a mix of preferred equity, common equity, and varying holding periods for each of them. To be effective in your diversification, you must prepare beforehand. Identify your goals, risk appetite, and strategy to get the right mix of investments for your portfolio. Through proper planning, you get to invest across the capital stack, enabling you to get the right risk and return advantages.
Preferred equity real estate investments are also known to be the ideal option for yield in case of a downturn in the market. A multitude of preferred equity investments showcase returns that exceed the S&P 500. This shows that there is a certain level of downside protection that these investments offer to their investors. Investing in multifamily preferred equity can ensure that you limit the risks of any losses that are a result of market downturns.
Lowered Costs and Higher Leverage For Sponsors
When looking at preferred equity from a borrower’s perspective, you will find that preferred equity offers sponsors a higher degree of leverage at a relatively lower cost as compared to financing common equity. Keep in mind however that this only prevails if the project performs well. Preferred equity can be a beneficial position for the real estate syndication sponsorship teams as they can get access to additional funding for their commercial real estate projects and take down more deals!
Preferred equity in real estate is a great investment for individuals seeking to earn secure passive income. There is no denying the many benefits that this type of investment comes with. So, if you’re looking for a way to get access to predictable and strong returns that offer you priority payment after the senior lender, you should consider preferred equity.