We all enjoy preferential treatment, no matter how humble we try to be. As investors, holding a preferred equity position in any investment comes with perks that the common equity holders don’t enjoy. In the stock market, preferred shareholders might see benefits such as dividends or the right to buy (call) a stock at a predetermined price and date, regardless of the actual cost of the shares.
In commercial real estate, preferred equity is similar, but the investment vehicle is a tangible property asset. Here’s a deep dive into the world of preferred equity in real estate, how it works, some of the benefits and some real-world examples.
What Is Preferred Equity?
Generally speaking, preferred equity is any private investment that puts the lender in a position where they take priority over common equity investors in repayment. Preferred equity investments also come with additional pre-determined benefits defined at the beginning of the lending process. Borrowers can acquire preferred equity funding from private equity groups, hedge funds, or other methods.
What Is the Difference Between Preferred and Common Equity?
The primary difference between preferred equity vs common equity is the level of risk. Because preferred equity has a higher position in the capital stack, it is paid off more quickly than common equity. Because the level of risk is higher in common equity, it enjoys more elevated rates of return. On the other hand, preferred equity investors take part in significant decisions and get control rights.
Preferred equity lives above common equity but below senior and mezzanine debt in the real estate capital stack. That structure means preferred equity is paid off after the senior and mezzanine debt but before common equity.
Example of a Preferred Equity Structure in CRE
In commercial real estate, preferred equity is a hybrid mechanism with features such as equity and debt. However, in its essence, preferred equity is neither debt nor equity. Instead, it’s an investment class all to its own.
The easiest way to paint a picture of preferred equity in real estate investing is to think of the overall property as a business, and in most cases it is. The project’s sponsor (developer or general partner) will set up an LLC specifically for the property for all loans, investments and business operations to flow through.
When the sponsor decides to utilize preferred equity as a source of financing, the preferred equity investors enter into the LLC, giving them some of the same rights as a business partner. Still, they don’t get any portion of the business’s profits or cash flow. Instead, they receive a fixed rate of return throughout the contract period, regardless of how the company performs.
How Is Preferred Equity Used in Commercial Real Estate?
CRE preferred equity is a kind of joint venture between the general partner and the equity investor or lender. Because deals are structured directly with developers and preferred equity investors, they get many privileges that common equity investors don’t.
When developers or GPs decide to use preferred equity to raise capital, they must share decision rights with the investors. While the GP will manage day-to-day operating decisions, the preferred equity partner will have to approve decisions regarding high-level decisions like capital expenditures, taking on new partners or investors, or property use. These decision rights are a primary example of how preferred equity more closely resembles ownership than debt.
Another way preferred equity resembles ownership is control rights. If a property defaults, general or limited partners lose their stake in the property. However, preferred equity investors retain their real estate ownership position (along with decision rights) when overall ownership transfers. In many instances, the preferred equity owners can take over full ownership rights of the property, but it all depends on how the deal is structured.
Preferred equity deals are structured in many ways. However, all preferred equity investment deals have a set rate of return for the contract’s life. Typically, a PE deal rate of return ranges somewhere between 7% to 12% but can go even higher depending on the terms. That means investors will receive the agreed-upon return regardless of how the property performs.
3 Benefits of Preferred Equity Investments
To help explain some of the main benefits of preferred equity investments, we reached out to Avi Zuckerman, Director of Capital Markets at Lev.
1. Easily Closes the Investment Gap
Securing funding for a big-money real estate project can be difficult, especially if sponsors try to do it themselves. Preferred equity is an excellent way to close an investment gap.
“Say, for example, you have a $35 million multi-family construction project,” Zuckerman explained. “The sponsor has put up $1 million of their own money, and they have limited partners with $4 million. Freddie Mac has provided a $20 million loan, and there’s $5 million in common equity. Preferred equity can easily be injected into the capital stack to cover the remaining $5 million.”
In many CRE projects, GPs scramble all the way up to the closing deadline to secure all the funding from investors. Preferred equity is a great way to get funding fast.
“If you have 30 days until close and still need $5 million, preferred equity is a fast and reliable solution over common equity,” Zuckerman said.
For general and limited partners in a CRE project, preferred equity is sometimes preferred for its affordability over mezzanine debt, also called subordinated debt, and common equity.
“It [preferred equity] isn’t as cheap as senior debt, but a &% to 11% rate is much more appealing than 14% or higher associated with common equity,” Zuckerman commented.
What’s Your Preference?
Because of its hybrid nature and flexible deal structure, preferred equity can be a difficult concept to grasp. Some developers and general partners might have difficulty finding preferred equity lenders they can trust having decision rights. However, when capital is needed quickly, preferred equity is a great place to turn to because of its affordability and speed of implementation. Working with an experienced CREF broker like Lev can help you secure funding, whether it’s through private equity or other means.