Preferred equity is a type of investment that can be a valuable tool for active and passive commercial real estate investors.
Unlike common equity, which represents an ownership stake in a property, preferred equity allows general partners or sponsors to provide passive investors with a predetermined rate of return without the same level of decision-making power.
By reading this blog post, you’ll learn the basics of preferred equity and how it can be used in commercial real estate investing. Let’s begin!
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What is Preferred Equity in Real Estate?
Preferred equity in real estate is a type of ownership in a property in which the investor receives a preferred return on their investment before the general partners and common equity holders receive any returns. Preferred equity holders receive priority distributions from the cash flow and profits of the property, typically over a predetermined period with a fixed rate of return.
To understand the priority of repayment, it’s essential to understand the real estate capital stack (a term for the collection of capital used to acquire a commercial property). In the capital stack, the senior lender or mortgage lender holds the first position on the property’s mortgage and will therefore receive priority for repayment. Next, if mezzanine debt is part of the capital stack, the mezzanine lender or mezzanine debt investors will receive the second repayment priority. Preferred equity holders are third in the repayment priority order, and common equity investors are last.
In case you haven’t heard of mezzanine financing before, a mezzanine loan is a loan that helps general partners close the gap between the amount of the senior loan, and the private equity the general partners can raise. Private investments in mezzanine debt typically hold the second mortgage in the capital stack and often receive a higher interest rate than the first mortgage or senior mortgage lender.
What are the Benefits of Preferred Equity in Real Estate?
Preferred stock is frequently utilized by general partners and sponsors to contribute extra funding to the project without taking on new debt. The general partners or sponsors may gain from this as it enables them to access additional funds without raising their leverage or risk.
Preferred stock is comparable to a debt investment for passive investors in that they are entitled to a predetermined rate of return on their investment. Preferred equity does not, however, have the same level of protection or priority as a debt investment in the case of failure or bankruptcy. Preferred stock often generates greater returns than conventional debt investments despite the added risk.
What are the Risks of Preferred Equity in Real Estate?
For general partners and sponsors, preferred equity is another debt obligation that must be paid. Suppose the numbers don’t work out the way they were projected, and the property doesn’t cash flow as well as anticipated. In this case, general partners and sponsors can miss their payments to senior debt holders, mezzanine debt holders, investors with a preferred equity position, and investors with a common equity position. This is not good and can cause many debt service problems.
For passive investors, preferred equity is considered riskier than senior position debt but less risky than common equity. Preferred equity is more complex than traditional debt investments because the investor’s return depends on the project’s success, creating a higher risk level than traditional debt investments with lower returns. As a result, it is essential to carefully evaluate the team of general partners and consider the potential risks and rewards of preferred equity before investing.
How is Preferred Equity in Real Estate Paid Back to Investors?
Preferred equity in real estate investments is usually paid back through the cash flow generated by the property. As the property generates income through rents or other sources, a portion of the cash flow is used to pay back all debt, including preferred equity investors. The investor with preferred equity will receive a predetermined rate of return on their investment, and they will receive their returns before the project sponsors and common equity investors.
The specific terms and conditions for the repayment of preferred equity depend on the terms of the investment agreement. The agreement typically specifies the rate of return the investor is entitled to receive, the payment schedule, and any other relevant details. Investors need to do their due diligence, carefully review the terms of the investment agreement, and consult with an investment advisor, financial advisor, and legal professional before engaging in preferred equity investing.
What is the Difference Between Common Equity and Preferred Equity?
The key differences between common equity and preferred equity in a real estate project boils down to the priority of the return and the way their returns are generated.
Regarding the priority of the return, preferred equity holders receive a higher priority of repayment from the property’s cash flow and sales revenue than common equity holders. Common equity holders receive their compensation after all other debt is paid off. The priority of the return is crucial to understand because it can make a substantial difference if the borrower defaults, files for bankruptcy, or experiences foreclosure.
Preferred equity holders receive regular interest payments throughout the holding period of the property. Payments are made at a predetermined interval with a predetermined rate of return from the property’s cash flow. Due to the predetermined rate of return, preferred equity holders have a ceiling on their returns, typically in the 10% to 15% range. Preferred equity holders often welcome this ceiling in favor of a more stable return and the preferred position in the capital stack.
On the other hand, holders of common equity take on the most risk because they don’t always receive consistent payments throughout the holding period of the property. Their returns are strictly dependent on the property’s profits which can be substantially more than the 10% to 15% the preferred equity investors receive if the property is successful. However, like with all investments, returns are not guaranteed so common equity investors take on more risk with more upside potential in the hopes of a higher rate of return from the event of a sale.
What is the Difference Between JV Equity and Preferred Equity?
The main difference between JV equity and preferred equity is the ownership interest and the priority of the return on investment. JV equity, or joint venture equity, is a type of equity investment in which two or more parties come together to invest in a property. In a JV equity arrangement, the investors share ownership and control over the property and are entitled to a predetermined portion of the profits and losses.
Preferred equity, on the other hand, is a type of investment in real estate in which the investor receives a preferred return on their investment before the general partner or other common equity investors receive any returns. Unlike JV equity, preferred equity does not provide ownership or control over the property. Instead, it is a form of debt-like financing in which the investor receives a predetermined rate of return on their investment.
In short, while JV equity and preferred equity can provide potential returns on investment, the two have significant differences. JV equity includes ownership and control over the property, whereas preferred equity does not. Additionally, JV equity investors receive a share of all profits and losses, while preferred equity investors are entitled to a preferred return on their investment.
Is Preferred Equity Considered Ownership?
Preferred equity in real estate is not considered ownership. Preferred equity is a type of investment in real estate in which the investor receives a preferred return on their investment before the general partner or other common equity investors receive any returns. However, preferred equity does not provide ownership or control over the property.
How is Preferred Equity in Real Estate Taxed?
Real estate preferred equity is typically taxed similarly to other types of investment income. The investor will be taxed on the profits they get from the investment, and the particular tax treatment will depend on the kind of company holding the investment along with the investor’s personal tax bracket.
Returns from preferred equity in real estate are almost always taxed as ordinary income. This means that the returns will be subject to the investor’s marginal tax rate, which is the tax rate applied to the investor’s highest taxable income bracket.
For investors who hold the investment through a pass-through entity, such as a partnership or a limited liability company (LLC), the returns from the investment will be passed through to the individual investors and taxed as ordinary income.
The tax treatment of preferred equity in real estate can vary depending on the specific circumstances of the investment and local tax laws. Always consult with a tax professional to determine the specific tax implications of a preferred equity investment in real estate.
How do You Calculate Preferred Equity?
In order to calculate preferred equity in real estate, you need to know the total amount of preferred equity in the asset as well as the projected rate of return for the investor. The investment agreement and other relevant documents related to the deal should contain this information.
To calculate the total return, just multiply the preferred equity amount by the rate of return once you have the numbers.
A 10% rate of return on a $100,000 investment in preferred stock, for instance, would result in a $10,000 total return.
What’s an example of preferred equity in commercial real estate?
Let’s look at a shopping center as a preferred equity real estate example.
In this scenario, let’s say an investor invests $500,000 in capital to the real estate developers of a shopping center as preferred equity. The developers and investor agree that the investor will receive preferred equity with an 8% return on investment. This means the investor expects to receive $40,000 per year in returns. Because this particular investor has preferred equity, they would receive their returns before the developers and common equity investors receive any returns.
In this example, the investor would not have any ownership or control over the shopping center. The investor simply receives a preferred return on their investment. On the other hand, the developer maintains ownership and control over the shopping center and is responsible for managing and operating the property. The developer is entitled to any remaining profits or losses from the shopping center after the preferred equity investor has received their returns.
As this example shows, preferred equity can be helpful for developers and investors in commercial real estate transactions because it allows the sponsor to access additional capital without incurring other debt, and it provides the investor with a potential return on their investment. However, it is vital for both parties to carefully consider the potential risks and rewards of preferred equity before entering into an investment agreement.
As another example of preferred equity in a commercial real estate deal, let’s look at a passive commercial real estate investor who wants to invest in an apartment building. The passive investor likes the business plan that the general partners have laid out, and the market conditions seem favorable so they decide to invest $100,000 in exchange for preferred equity with a 9% return on their initial investment. This means the passive investor expects to receive $9,000 per year in returns.
Preferred equity is one of two equity investments often used to fund commercial real estate deals. It is like a hybrid of debt that combines equity and debt financing elements. In a preferred equity arrangement, the investor provides capital to the borrower in exchange for a predetermined rate of return.
Preferred equity is often used when the borrower cannot obtain the traditional financing that covers the total purchase price of a property. Because of this, preferred equity deals are a valuable tool that help general partners secure commercial real estate deals while also providing great investment opportunities for passive investors and limited partners.
If you’re interested in building your investing knowledge further, look through our glossary of important real estate investing definitions.