Lester Freeman
Preferred equity is a form of equity investment that can be structured into a commercial real estate project to strike a balance between risk and reward. It sits between senior debt and common equity in the capital stack, the structure of all capital sources and their repayment priority in a commercial real estate project. While it has a lower risk than common equity, it is still considered higher risk than senior debt. Preferred equity investors are typically offered lower returns than common equity investors but are paid any potential returns first, and they have more certainty of being paid. However, they may have less control over the property and face challenges in recovering their investment in the event of a sale or liquidation.
| Characteristics | Values |
|---|---|
| Priority of repayment | Preferred equity investors are paid before common equity investors |
| Certainty of payment for stabilized assets | Preferred equity can be a good option for regular distributions when an asset has a strong and durable net operating income |
| Downside risk exposure | Common equity investors incur losses before preferred equity investors |
| Upside potential | Common equity investors will earn higher returns than preferred equity investors if a project is successful |
| Risk of loss | Preferred equity investors are exposed to the risk of a full loss |
| Liquidity | Preferred equity is less liquid than common equity |
| Control over the property | Preferred equity investors have less control over the property than common equity investors |
What You'll Learn
Higher risk, higher return
A preferred equity investment profile is a class of shares that give the holder a higher claim to dividends or asset distribution than common stockholders. Preferred equity investors get back their initial investment plus an established percentage return before other investors receive anything. This type of investment is often used in private equity and real estate investment.
Preferred equity can be structured to look similar to debt or common equity. It can be debt-like, with a pre-specified fixed rate of return, or common-equity-like, with no guaranteed payout.
Preferred equity investors typically face more risk than debt holders but have a higher claim to dividends or asset distribution than common stockholders. This means that preferred equity investors can have a higher risk of loss than common stockholders but a lower risk than debt holders.
Preferred equity can be a high-risk, high-return investment. If a project is successful, common equity investors will usually earn higher returns. However, if a project fails, preferred equity investors will be paid out before common equity holders, meaning they have a level of downside protection.
Preferred equity investors can also have the potential for upside benefit if the deal generates returns above the preferred minimum. In this case, they will collect a percentage of the upside. This makes preferred equity a flexible financing option that can be structured to suit the needs of the investor.
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Priority on liquidation
A preferred equity investment profile is a class of shares that give the holder a higher claim to dividends or asset distribution than common stockholders. In the event of a company liquidation, preferred stockholders have a higher claim on assets than common stockholders but a lower claim than bondholders.
Preferred equity investors are typically offered lower returns compared to common equity investors, but they are paid any potential returns first. This is referred to as having "priority on liquidation". This means that, in the event of a company liquidation, preferred equity investors will be paid back their original investment before common equity investors.
The priority of repayment to preferred equity investors can be for both repayment of invested capital and some or all of the preferred return. The level of priority is usually negotiated when structuring the deal.
Preferred equity investors also have more certainty of payment than common equity investors, as they typically receive their current return before any cash flow is distributed to common equity investors.
In the event that the asset does not perform as expected, common equity investors will incur losses before preferred equity investors.
However, it is important to note that preferred equity investors are still exposed to the risk of a full loss. In the event that a company is liquidated and the proceeds are not sufficient to cover the preferred equity position in the capital stack, preferred equity investors will incur a 100% loss.
Overall, priority on liquidation provides preferred equity investors with a level of protection against downside risk, but it does not guarantee a full return of their investment in the event of a company liquidation.
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Reduced control
Preferred equity investors may have less control over the property compared to other types of investors. Mezzanine lenders, the predominant type of preferred equity holders, are typically subordinated to other lenders, including the senior lender or the property owner. This means that they have less influence over the property and may face challenges in recovering their investment in the event of a property sale or liquidation.
Preferred equity investors' ownership is not directly tied to the property value. While the inclusion of preferred equity can enhance the asset's long-term profitability, investors in preferred equity do not directly participate in the appreciation of the property's value. They do not share in any gain during the final payout, even if the property experiences a significant increase in value.
Preferred equity investors also do not have the option to initiate foreclosure proceedings if the borrower defaults on their loan. This is because preferred equity is secured by shares of stock in the entity that owns the property, not the property itself. This means that in the event of a foreclosure, the senior debt holder takes title to the property and sells it, using the proceeds to repay the loan.
Preferred equity investors may also find it challenging to recover their investment in the event of a sale or liquidation due to their reduced control. Their investment is not liquidated, and their ownership is not directly tied to the property value, so they may encounter difficulties in selling their stake in the property if the need arises.
Despite these considerations, preferred equity can be an attractive option for investors seeking to diversify their investment portfolio. It offers a stable investment opportunity with a fixed rate of return, providing a consistent income stream compared to other forms of passive real estate investments.
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Less liquidity
Preferred equity is considered to have less liquidity than common equity investments. This means that selling your stake in the property may be more challenging if the need arises to liquidate the investment. This is because preferred equity is not secured by the real estate property itself but by an interest in the entity that owns the property. This creates an extra layer of complexity when it comes to selling.
Preferred equity investors typically require a higher return to compensate for this higher risk. They are also more likely to incur losses in the event of a foreclosure or bankruptcy, as their claims on residual assets would typically rank behind those of bondholders and secured creditors.
In addition, preferred equity investors may have less control over the property compared to other types of investors, such as mezzanine lenders, who are typically subordinated to other lenders but have more influence over the property.
The illiquid nature of preferred equity investments is a key consideration for potential investors, particularly those who require their capital to remain liquid or need access to their funds within a shorter timeframe. Real estate, in general, may not be a suitable investment avenue for those seeking liquidity, as capital in a preferred equity investment is typically illiquid and can be challenging to withdraw.
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Steady cash flow
Preferred equity investors receive all cash flow or profits once all debts are repaid, and they continue to receive payments until they achieve the agreed-upon return. This means that, in the event of a sale or liquidation, preferred equity grants priority to the investor over common equity holders.
Preferred equity investors are also protected from downside risk. In the event that the asset does not perform as expected, common equity investors incur losses—up to 100% of their invested capital—before preferred equity investors incur their first dollar loss.
Preferred equity can be structured to look similar to debt or common equity. In its more certain form, preferred equity can possess features that simulate debt, such as a pre-specified, fixed total rate of return, a requirement for a certain level of return to be paid as it is due, and a maturity date that requires repayment.
However, it is important to note that preferred equity lacks the upside potential of common equity. If a project is successful, common equity investors will earn higher returns. Preferred equity investors will either receive a targeted return or a limited share of the upside, but this will be far less than what is paid to common equity investors.
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Frequently asked questions
Preferred equity is a class of ownership interest in a commercial real estate property, secured by shares of stock in the entity that owns the property, rather than the property itself. It is considered riskier than senior debt but less risky than common equity.
Preferred equity sits between senior debt and common equity in the capital stack. It gets repaid after all debts are repaid but before common equity holders. Preferred equity investors typically receive a flat annual return plus some sort of equity kicker, which entitles them to profit participation if the property is sold at a profit.
Preferred equity offers a stable investment opportunity with a fixed rate of return, regular distributions, and priority over common equity holders in the event of liquidation. It is an attractive option for investors seeking to diversify their portfolio and those seeking a balance of higher yield with a consistent return.
Preferred equity carries a higher level of risk compared to common equity investments. Investors may have less control over the property and face challenges in recovering their investment in the event of a property sale or liquidation. Preferred equity investments also offer less liquidity than common equity investments.
Preferred equity can be sourced from various entities, including hedge funds, family offices, venture capital funds, real estate syndication companies, and private individuals. It is important to conduct due diligence on the property, market, and offering before investing.
