What You Need to Know About Preferred Equity in Real Estate
October 7, 2022
If real estate investing interests you, there are many ways to get involved. You likely know of the debt or equity options, but there is another option: preferred equity in real estate.
A preferred equity investment is higher than common equity and yet lower than any loans, including the first and second mortgage debt.
Here's everything you need to know about preferred and common equity and what you should consider.
Understanding Preferred Equity in Real Estate
Preferred equity in real estate is most commonly used in high-value commercial real estate projects. It's a method to gather more financing for a real estate project than sponsors and real estate syndicators might get with bank financing and regular investing options alone. It's a part of the capital stack to help real estate companies finance a project.
Preferred equity investors don't mind a fixed rate of return and have a large amount of capital to invest. As a result, it's often a great way to diversify an investment portfolio from other higher-risk investments.
What Is Preferred Equity?
So, what exactly is preferred real estate equity? You get the idea if you're familiar with preferred and common stocks. Preferred equity ranks higher than common equity, meaning investors receive payment before common equity investors when the property is sold or there is a default.
Often, preferred equity in real estate is the remaining capital a real estate sponsor or syndicator needs to meet the property's purchase price.
Here's a preferred equity investment example, if a syndicator wants to purchase a commercial real estate property for $10 million, the bank will loan $6 million. They've raised $2 million from common equity investors, with $2 million remaining cash flow.
Rather than looking for a second mortgage lender charging high-interest rates, they can offer preferred equity investments to investors. However, they must choose a fixed rate of return, such as 7 - 8%, to attract investors.
You might wonder why anyone would choose a 7 - 8% return when they might make more elsewhere. Many investors have a certain amount of capital they want to keep in a somewhat conservative investment, and a return between 7% - 12% is suitable for many investors.
Preferred Equity Investments: Pros and Cons
Like any investment, preferred real estate equity has its pros and cons. Here's what you should know.
- It might be a safer return - Since preferred equity is paid out before common equity, investors have a higher chance of receiving funds in their real estate deal.
- There's a fixed yield - Investors know how much an investment will yield ahead of time because it's a fixed rate of return.
- Investors have an ownership interest in the property - This may allow preferred investors to have tax benefits or have a say in the decisions.
- Preferred equity is below debt - If the property doesn't perform how the real estate company anticipated, there's a chance preferred equity investments don't get paid.
- The real estate equity investment isn't secured - There is no guarantee investors will receive a payout, unlike the secured mortgage debt.
- There's no chance for an increase in earnings - Even if the property outperforms how the real estate company thought it would, investors don't receive any higher payout than what they were promised in the preferred equity deals.
How Preferred Equity Investments Are Structured
There are several ways somebody can structure preferred equity investments. It depends on how many investors take advantage of the preferred equity and how the sponsor company is structured.
Real estate equity investors have a stake in the company, similar to a business partner. However, they don't receive any profits if the property outperforms their expectations. In addition, the investment has a fixed rate of return, which puts preferred equity investors at a slight disadvantage if the property performs well.
Sometimes, the investor is a single person or entity, filling the entire gap in financing needed. As a result, this investor receives payment before common equity investors receive a penny from the investment.
It's important to note that preferred equity investors receive payment after any senior debt, as well as any mezzanine debt or second mortgage. Any mortgage debt on the property has priority, then preferred equity investors get paid.
Preferred Equity vs. Common Equity
You might wonder, what's the difference between preferred equity and common equity holders? They both invest money, so they should receive payment when the real estate company sells the property or the owner defaults, right?
In a perfect world, all lenders and investors get paid. It's the order they get paid that matters.
Lenders with senior debt, as well as mezzanine debt, receive payment first. Therefore, the senior lender has top priority and the second mortgage lenders come next.
Once all lenders have been paid, preferred equity investors are next in line. Only preferred equity investors may receive a payment if there isn't enough money left to pay common equity holders.
Benefits of Preferred Equity Investments for Real Estate Companies
Just as preferred equity holders benefit from the real estate investment opportunity, real estate companies benefit too. Here's how.
Easily Closes the Investment Gap
When real estate companies have a gap in the necessary funds for real estate investments, they can close it with a preferred equity structure. Offering preferred real estate equity may motivate institutional investors or large companies to invest versus individual investors. This can be especially helpful when real estate developers need a large amount of capital to fill the gap.
Preferred equity usually costs real estate companies less than mezzanine financing. However, because mezzanine debt is a second mortgage, a mezzanine loan is riskier. There's a senior debt that has priority over it, which means there's a chance the second mortgage lender won't get paid.
Real estate companies can save money by using an equity investment to close the gap. Of course, they'll still pay a fixed rate of return, but they can often get by with lower interest rates than lenders charge.
There are fewer hoops to jump through when offering a preferred equity investment versus getting mortgage financing. Second, mortgage financing has more risk, so lenders do a lot of due diligence to ensure you qualify. There's a chance it could delay the purchase of the property or even cause the sale to fall through if financing doesn't work.
When offering the option to preferred equity holders, real estate companies can receive the capital much faster, allowing them to close on the property quicker.
Preferred Equity Fees & Risk
Preferred equity usually costs commercial real estate companies more than senior debt costs. That's because senior debt uses the property as collateral. If the company defaults, the bank can take possession of the property and sell it to get its money back.
Because that's not an option for preferred equity holders, they demand a higher rate of return to make up for the risk.
If the company goes as far as to offer common equity holders investments, this costs the company even more money. While common equity holders don't have a fixed rate of return, they have a stake in the company's profits. If the company outperforms its expectations, common equity holders may receive a portion of the rental income and profits.
Preferred Equity Investment FAQs
How Is Preferred Equity Paid Out?
Preferred equity holders receive a payout after all debts from secured lenders are paid. This usually means the senior debt holder and any mezzanine debt holders. However, many real estate companies bypass the mezzanine debt holders and replace them with preferred equity investments. So anyone in a preferred equity position gets paid after senior debt and possible mezzanine debt.
What Is a Preferred Return in Real Estate?
The preferred return is the money an investor must receive before any other managers, common equity shareholders, or anyone else can receive payment from the investment.
Is Preferred Equity Secured by Real Estate?
Preferred equity isn't secured by real estate. Instead, it has an interest in the company that owns the real estate. Preferred equity real estate shareholders have priority over common equity shareholders, but they don't have the luxury of the real estate's collateral.
What Is the Difference Between Equity and Preferred Equity?
Equity is common equity owned by any investor. These are the last investors to receive a payout when the property is liquidated or the borrower defaults.
Is Preferred Equity a Loan?
Preferred equity isn't a loan, but it often takes the place of a second mortgage. A loan has the home as collateral, but preferred equity doesn't have collateral. Instead, it's an investment with a fixed rate of return if everything goes as planned.
Does Preferred Equity Have Interest?
Preferred equity receives a fixed return rate determined before the investor invests. The rate doesn't change, and the investor doesn't earn more money if the property outperforms expectations.
How Does a Preferred Stock Work?
Preferred stocks have a fixed par value. They may also receive dividends based on the company's performance. Like a preferred equity investment, preferred stockholders receive payment before common stockholders when liquidating.
What Is Preferred Equity on a Balance Sheet?
Preferred equity is listed at the top of the shareholder's equity section.
How Do You Calculate Preferred Equity Return?
To calculate the preferred equity return, investors multiply the promised rate of return by the investment times. For example, if an investor invested $500,000 at an 8% return, the preferred equity holder receives $40,000.
Is Preferred Equity Debt or Equity?
Traditionally, preferred equity is an equity investment because it's not debt but falls somewhere between debt and equity.
What Is Equity in Real Estate?
Equity in real estate refers to the difference between a property's current value and the outstanding loans. For example, if a commercial real estate property is worth $1 million and has $500,000 in unpaid loans, the equity is $500,000. A similar model could be used when thinking about home equity investments.
Are Preferred Equity Investments Safe?
Due to the limited control preferred equity holders have over property, preferred equity investments are considered to be riskier than common equity investments.
What Is the Minimum Investment for Preferred Equity?
Investing in preferred equity does not have a set minimum investment, but most investments require $100,000 or more to get started.
Preferred Equity in Real Estate - The Bottom Line
If you have the extra capital that could use a fixed rate of return to balance out your portfolio, then preferred equity in real estate may be the perfect option. You'll have a higher chance of receiving a payout than common equity holders, but you aren't investing in debt. Discover more by signing up and visiting our blog.
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