When it comes to financing, there are quite a few different points of entry when it comes to investing in commercial real estate. At the bottom of the capital stack, you have senior then mezzanine debt.
After that is preferred equity, with common equity at the very top. For an investor, figuring out the best method of investing depends on what you’re looking to gain and what you’re willing to risk.
Here we’ll help break down the difference between preferred equity vs common equity and weigh the pros and cons of each.
What Is the Difference Between Preferred Equity vs Common Equity?
Preferred and common equity both give borrowers more access to equity capital when making a commercial real estate investment. For lenders, both forms of equity subordinated equity, which acts as an equity cushion.
Vince Muselli and Evan Pozarny of Muselli Commercial Realtors in Southern California explained the importance of preferred and common equity.
“Our marketplace is the Santa Monica and adjacent areas. Property values for developments and existing commercial properties are generally higher than in many areas of Southern California. Many of our higher price transactions would not be possible without preferred or common equity.”
So what are the differences between preferred equity vs common equity?
What Is Preferred Equity?
Preferred equity investments act similar to mezzanine debt in the sense that they offer lenders the possibility of a high reward and gives borrowers supplemental capital in addition to the senior loan. Nonetheless, PE is lower priority on the capital stack than senior debt from a traditional lender.
The term “equity” represents ownership in an asset. It is “preferred” because they are paid back an agreed upon “preferred return” of cash flow after senior debt, and before common equity has been repaid.
What Is Common Equity?
Common equity is often referred to as “having skin in the game,” as this financial source comes from the developers or sponsors of the property, as well as joint venture (JV) partners or limited partners (LP) that invest their own money.
These are usually the people who find, acquire and manage the property.
After senior debt and preferred equity are paid, common equity holders receive an equal distribution of the remaining cash flow or value.
While common equity typically involves more risk, it also offers more potential return on profit.
Pros and Cons of Preferred Equity vs Common Equity
Now that we see the importance of preferred and common equity, let’s break down the pros and cons of each.
Preferred Equity Pros
There are quite a few benefits for those looking to invest in preferred equity real estate.
- Safer Return: Preferred equity investors receive cash flow before common equity.
- Investors Receive Yield: Investors receive a percentage of the annual income from the asset.
- Steady Rate of Return: Preferred equity offers investors a more steady rate of return than with common equity.
- Ownership Interests: Preferred equity holders have ownership interests in the entity. This sometimes looks like investors being able to participate in the tax benefits associated with the investment.
Preferred Equity Cons
- Loss of Capital: Although preferred equity is more stable than common equity, it is still junior on the capital stack to debt. If a property doesn’t reach enough of a return, investors may lose out on their investment.
- Equity is Not Secured: Ownership interests are not secured, and they may not have recourse to a property if the borrower defaults on the loan.
- Doesn’t Receive Upside: These investors typically do not gain from the potential increase in value of a property. In the case of participating preferred equity, equity investors may benefit from some upside.
Common Equity Pros
- Highest Return: Common equity typically offers the highest return, or IRR – Internal Rate of Return.
- Unlimited Potential Earnings: There is usually no cap on potential return for common equity investors.
- Receives Upside: Common equity investors benefit from any potential increase in property value, as well as tax benefits like deductions.
- Long-Term Growth: This benefit is good for investors who are in it for the long haul, as common equity offers the potential for long-term growth and profit.
Common Equity Cons
- Paid Last: Common equity investors are the last in the capital stack to receive a return on their investment after senior debt and preferred equity holders.
- Last for Foreclosure Rights: In the case of a foreclosure, common equity investors are the last to receive foreclosure rights.
- Highest Potential Loss: The high rate of potential return comes with the risk for the highest potential loss amongst common equity holders.
- Equity is Not Secured: Same as with preferred equity.
Why Include Preferred Equity in a Capital Stack?
If you’re looking for investors for a commercial real estate project, you may be wondering why you should include preferred equity in a capital stack.
Muselli and Pozarny said, “Senior lenders have become more conservative in their underwriting due to the Covid-19 environment. For borrowers, many transactions would not be viable without preferred equity and/or common equity.”
Because the pandemic has made it more difficult for borrowers to obtain as much leverage from a traditional loan as they may have in the past, they are able to gain leverage for larger projects through preferred and common equity. Another big benefit is that a higher amount of preferred equity typically boosts the IRR.
Preferred Equity and Common Equity FAQs
Is preferred equity debt?
Preferred equity is technically not a debt. Nonetheless, borrowers must pay back the initial investment plus the agreed upon “preferred return.”
For tax purposes, however, preferred equity is most often treated as a debt. It is important for the lender to recognize their investment as equity, otherwise, it may be disallowed by them or trigger further review.
How do you calculate preferred equity?
Here’s how to calculate preferred equity in the capital stack:
After debt, preferred equity holders are paid a fixed rate of return from all cash flow earned in a month or quarter. In addition, they are also paid a fixed rate in their share of equity, which can range anywhere from 7 to 12% or higher.
What is the Loan-to-Value Ratio?
Loan-to-value ratio is the amount a lender is willing to invest compared to the value of the property.
Because most debt lenders will not offer a loan that is greater than 80% LTV, many borrowers turn toward preferred and common equity for greater leverage. Preferred equity will usually go from 85% to 90% of LTV. They may factor budgeted renovation costs into the value, or determine it using an LTC (loan to cost) calculation, which further can increase leverage.
Is preferred equity the same as preferred stock?
Preferred equity in commercial real estate functions similarly to preferred stock in other forms of investments. Just like in the stock market, capital stacks in private commercial real estate deals create equity classes to decide which equity holders are paid first, and what the return on their investment is.
The main difference between the two is that preferred equity is typically used in the world of commercial real estate, while preferred stock is used to discuss other forms of investment like investing in a startup company.
Understanding Preferred Equity vs Common Equity
Both preferred and common equity offer the potential for a high return on investments.
Preferred equity holders take more risk than traditional lenders, but less than common equity holders. Yet common equity holders have the potential to make more on their investment as a trade-off for that risk.