Equity Investment: Understanding Preferred Equity

Preferred equity is a form of equity investment that can be used in commercial real estate projects 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 project. This means that preferred equity investors are prioritised over common equity investors in repayment but are subordinate to senior debt positions. As a result, preferred equity investors benefit from higher returns that pay out sooner than common equity, but they may not receive as much of the upside as other investor classes.

Characteristics of Preferred Equity Investment

Preferred equity is preferred over common equity in repayment priority

Preferred equity is a form of equity that can be structured into a commercial real estate project to strike a balance between risk and reward. It is often used when there is a gap between the investor capital and the senior loan. In the capital stack, preferred equity sits behind senior debt and ahead of common equity. This means that preferred equity investors are prioritised over common equity investors when it comes to repayment.

Preferred equity investors are typically offered lower returns than common equity investors but are paid any potential returns first. This can make an investment more attractive in uncertain times when the potential for high returns is unclear. The priority of repayment can be negotiated when structuring the deal, and can apply to both repayment of invested capital and some or all of the preferred return.

Preferred equity can be structured to look similar to debt or common equity. In its more debt-like form, preferred equity may possess features 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 regardless of whether the project has been sold.

In its common-equity-like form, preferred equity may not guarantee a payout; distributions are based on the performance of the asset. This is referred to as "soft pay" preferred equity. It also occupies a subordinate position to all debt in the capital stack in terms of repayment and offers the potential for profits participation.

Preferred equity can be beneficial in a number of scenarios. For example, it can be used to fill a funding gap in a new acquisition or a refinance. It can also be a creative solution in today's lending environment, where rising interest rates and tightening restrictions are causing challenges for syndicators. By investing in preferred equity, individuals can secure a prime spot in the capital stack, receive consistent ongoing returns, and diversify their portfolios.

It is subordinate to senior debt positions

Preferred equity is a form of equity that can be structured into a commercial real estate project, creating an investment that balances risk and reward between senior debt and common equity. It is a flexible form of investment that can be structured to resemble debt or common equity.

While preferred equity is "preferred" over common equity in repayment priority, it is subordinate to senior debt positions. This means that in the event of liquidation, preferred equity investors will be repaid after senior debt holders but before common equity holders. Senior debt is typically provided by banks and is considered a loan to the property, which is usually secured by recorded liens. In the case of default, lenders can institute recovery efforts and take possession of the property.

Preferred equity, on the other hand, does not receive a share of the profits and is not treated as debt. Instead, it fills the gap between debt and common equity, providing a middle layer of capital in the capital stack. This means that preferred equity investors have a lower risk than common equity investors but a higher risk than senior debt holders.

The priority of repayment to preferred equity investors can make this type of investment more attractive, especially in uncertain times or when there is a gap in funding. It offers a way to invest in real estate without taking on the responsibility of direct ownership and provides the potential for higher returns that are paid out sooner than common equity.

It can be structured to have both debt and equity-like features

Preferred equity is a flexible form of investment that can be structured to have both debt and equity-like features. It sits in a priority position of repayment to common equity but is subordinate to senior debt. This means that while it has a lower risk profile than common equity, it is still considered higher risk than senior debt.

Preferred equity can be structured to resemble debt by offering a pre-specified, fixed total rate of return. This is known as "non-participating" preferred equity, as investors do not participate in any additional potential upside. This type of preferred equity may also include features such as a maturity date that requires repayment regardless of the project's status and an obligation to service the preferred return on a defined cadence, known as "hard pay" preferred equity.

On the other hand, preferred equity can also be structured to resemble common equity, with no guaranteed payout and distributions based solely on the performance of the asset. This is referred to as "soft pay" preferred equity. This type of preferred equity may include features such as a subordinate position to all debt in the capital stack and the ability to participate in the profits of the project without limits, known as "participating" preferred equity.

The flexibility of preferred equity allows sponsors and investors to creatively structure the investment to meet their specific needs and goals. It provides an opportunity to strike a balance between risk and reward, making it an attractive option for investors looking to enter the commercial real estate market.

It can participate in project profits without limits or be capped

Preferred equity is a form of equity that can be structured into a commercial real estate project to strike a balance between risk and reward. It sits between debt and common equity in the "capital stack", which is the structure of all capital sources and their repayment priority in a commercial real estate project.

Preferred equity can be flexibly structured to have both debt and equity-like features. It can participate in the profits of a project without limits, referred to as "participating" preferred equity, or be capped, referred to as "non-participating" preferred equity.

Participating preferred equity has an uncapped upside, meaning that investors can participate in the profits of a project without limits. This type of preferred equity is similar to common equity in that it has no guarantee of payout and is subordinate to all debt in the capital stack in terms of repayment. However, it offers a higher targeted return compared to debt positions and even debt-like preferred equity positions.

Non-participating preferred equity, on the other hand, does not participate in the profits of a project and is capped. It is similar to debt in that it has a pre-specified, fixed total rate of return. This type of preferred equity may include features such as a maturity date that requires repayment regardless of whether the project is sold and fees or penalties for failing to pay the current return as it is due.

By investing in preferred equity, investors can secure a prime position in the capital stack, ahead of common equity holders, and benefit from consistent ongoing returns. Preferred equity may also offer the opportunity to participate in strong assets and help ensure their continued success, particularly in a challenging economic environment.

It can be used to fill financing gaps

Preferred equity is a flexible form of equity that can be used to fill financing gaps in commercial real estate projects. It is often used when there is a gap between the amount of capital available from investors and the amount needed to close a deal or complete a purchase. This type of investment can be structured to have both debt and equity-like features, depending on the specific needs of the project.

In a typical capital stack, preferred equity sits behind senior debt and ahead of common equity in the repayment priority. This means that preferred equity investors have a lower risk than common equity investors but a higher risk than senior debt. The flexibility of preferred equity allows it to be structured to look similar to either debt or common equity.

When a financing gap exists, preferred equity can be used to fill this gap and move the project forward. For example, if a syndication group is acquiring a multifamily asset and there is a gap between the loan amount and the required down payment, preferred equity can be offered to sit between the senior loan and investor equity. Similarly, in a refinance scenario, preferred equity can be brought in to fill the funding gap and enable the successful completion of the refinance.

Preferred equity investors benefit from higher returns that pay out sooner than common equity. As a result, if a real estate deal underperforms, preferred equity holders bear less risk than those who own common equity. Preferred equity typically receives a higher yield compared to debt and has a lower risk due to its position in the capital stack. However, it may not receive as much of the upside potential compared to other investor classes.

Overall, preferred equity is a valuable tool for filling financing gaps in commercial real estate projects. It provides investors with a prime position in the capital stack, consistent returns, and the opportunity to participate in strong assets.

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