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Finding ways to passively earn a return that reduces risk exposure is the goal of every investor whether you're placing money in the stock market or in a private fund or crowdfunding opportunity. Preferred equity is a special financing structure that is common among large commercial real estate investments or private equity funds which can provide participating investors with additional security on their investment while providing the active investors leverage to more capital for an investment.
If you're unfamiliar with the term "preferred equity" or how it's used in real estate, continue reading to find out what preferred equity is, how it works, and how it differs from other lending structures.
What is preferred equity?
Preferred equity is a type of capital structure that places a private lender in a priority position for repayment from any cash flow or profit earned from a particular investment over others. Their preferred equity position places them behind the repayment of a senior lender such as a first or second mortgage from a traditional bank or lending institution but in front of other participating investors or sponsors.
Similar to preferred stock, this preferred equity security reduces some risk exposure for the preferred equity investor because it places greater importance on the repayment of their debt above common shareholders or common equity investors. The preferred equity investor earns preference shares, which typically have a higher rate of return than other lenders because they are at a slightly lower lien position than senior debt holders, which carries a higher level of risk.
How is preferred equity used in real estate?
Preferred equity financing is most commonly used with large real estate investments where additional funds are needed beyond what a senior debt like a bank will or can provide. Rather than borrowing the additional funds from one or a few investors in the form of a loan that holds a second or third lien position, they offer preferred equity positions to equity investors. In the financial world, the multiple layers of capital are referred to as a capital stack, because the borrower or sponsor is stacking different financing terms and priority positions on top of each other.
Example of preferred equity structure
Most preferred equity structures are fixed rates of return for a specified period of time, which could be one year to five years or more. Since most commercial loans are for shorter terms, five to ten years, it's likely the sponsor will refinance or liquidate the property repaying all debt including equity investors in a period of ten years or less. Some preferred equity structures will include a percentage of shared equity in the property, so if and when the property appreciates and the asset is sold, they earn a percentage of the gained appreciation earned in liquidation.
The easiest way to understand this is to look at a hypothetical but common example of a capital stack that uses preferred equity. Let's say an investor is looking at purchasing a value-add apartment complex for $2 million. The investor in this scenario is called the sponsor because they are doing the work and sponsoring the investment, overseeing the contractors, property managers, and ensuring the investment is completed as intended.
Because the property is underperforming, there's an estimated $350,000 in additional capital needed for renovations and holding costs while the property is being improved and re-leased. The sponsor is able to finance the property with a traditional lender, putting 20% down plus financing fees and due diligence costs (estimated $30,000), bringing their upfront investment need to close and execute the investment as intended to $780,000.
The sponsor puts $100,000 of their own money into the investment but still needs to raise $680,000. They decide to use a capital stack offering a preferred equity investment, paying the preferred equity investors an 8% return from any cash flow or revenues after the senior debt holder (the bank) and before they take any income.
|Sponsor||$100,000 invested||Gets paid last||Lowest priority||Benefits from remaining cash flow, appreciation, and tax benefits of owning real estate|
|Preferred Equity Investor||$680,000 invested (can be combined from several investors)||Gets paid second||Secondary priority||Earns a fixed rate of return from all revenues or cash flow earned each month or quarter in addition to possible equity share, often 7% to 12% or more, depending on the investment opportunity.|
|Senior Lender (Bank)||$1,600,000 lent||Gets paid first||Highest priority||Earns a fixed or variable rate of return that is often lower, 4% to 7%.|
As the sponsor renovates and improves the property, they pay a preferred return of 8% per month to the participating investors after the monthly mortgage payment. After a year and a half, the sponsor has reached the target occupancy of 90% with all units renovated and is able to sell the property for $4.2 million by the end of year two. The sponsor pays off the remaining balance due to the bank, then repays the preferred equity investors before taking any remaining profits. In this scenario, the sponsor would still walk away with well over a million dollars in profits even if sharing a portion of the equity with the preferred investors.
Additionally, the sponsor could refinance the property with a new lender, paying off the preferred lenders so they can keep their performing, cash-flowing income property for a longer period of time.
How preferred equity differs from common equity
When an investor participates as a common equity investor, they are buying into the property or investment opportunity, essentially purchasing shares or a percentage interest of the potential profit after the liquidation of the property. Common equity investors are paid after preferred equity investors and may not receive a portion of cash flow or revenues while the investment is held. They also share in the potential loss of the investment. A common equity holder is carrying more risk with their investment but also has the potential to earn a higher return if the property value improves or increases as intended because they have an equity interest.
Is a preferred equity investment safe?
A preferred equity investment is less risky than other types of investments like a joint venture or common equity, but it still carries risk. Preferred investments are not guaranteed; no investment is. Because this type of financing structure is most commonly used in value-add opportunities, there is always the chance that the asset or investment doesn't reach pro forma projections. While it does place a priority for debt repayment, there is always the risk that the deal goes south. In the event of bankruptcy, the priority position will be considered.
If you're considering investing in a private equity fund, partnering with or lending to a sponsor on a private investment, or investing in a crowdfunding opportunity that is using preferred equity financing, make sure to carefully consider the investment opportunity and the sponsor. Since the sponsor is one of the largest factors in the success of the investment, due diligence should be done on their past performance, knowledge, experience, and reputation in the business. It's also up to you as the equity investor to thoroughly evaluate the investment opportunity. That said, this method of investing can be profitable for both lenders and active investors.
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