What is the Difference between Preferred Equity and Common Equity in Commercial Real Estate?
In commercial real estate, investments can take on many forms, and part of the investors’ job is to determine where they want to invest in the capital stack. The capital stack is a concept that deals with the different types of financing (both equity and debt) to commercial real estate deals. For instance, at one end of the capital stack are the senior debt holders who take on less risk by lending money, usually secured by the real estate asset, and in return they receive interest payments. A senior loan carries less risk because a senior lender would be the first to get paid back in the event that the issuer became insolvent or went bankrupt. Sometimes senior debt holders also have a claim against the physical asset that the loan finances, in this case commercial real estate. This means that in the event of a default or bankruptcy, the senior debt holders could end up as equity owners of the asset they initially financed. They might be able to use this position to manage the asset or sell it to other real estate investors.
On the other end of the capital stack are investors who take equity positions. Equity investors assume more risk and are the last to be paid back in the event of a default. In between senior debt holders and common equity holders are mezzanine debt holders and preferred equity investors. A mezzanine loan is similar to senior debt except that it stands lower in the capital stack and often is not secured by the real estate asset. Preferred equity investments borrow features from debt and equity as we will see below.
Preferred Equity vs. Common Equity: Level of Risk
Risk in the capital stack is usually measured by the level of seniority and downside protection that the investment has relative to others. Preferred equity holders are typically senior to common equity holders in the capital stack. This means that in the event of a default or bankruptcy by the issuer, the preferred equity holders would be paid out before the common equity holders. Many times the common equity holders receive nothing during bankruptcy proceedings. For this reason, common equity investments are considered higher risk.
In addition to preferred equity being higher in the capital stack compared to common equity, preferred equity distributions, namely dividends, often have an arrearage feature included. This means that if the issuer of the preferred equity fails to make a dividend payment, the preferred equity investor is entitled to receiving the late dividend before future dividends can be paid out. Preferred equity dividends paid late or known as dividends paid in arrears. Common equity on the other hand, does not have this feature. In other words, if the common equity issuer misses a dividend payment, common equity investors do not have a right to repayment of the missed dividend.
Preferred Equity Pros
Preferred equity has certain advantages that investors might be attracted to depending on their risk profile and investment objectives.
Receive Cash Flow Earlier
Preferred equity typically has a higher dividend yield compared to common equity. Because of this, preferred equity investors usually receive more cash flow earlier in the life of the investment. Preferred equity holders are free to reinvest this cash flow into any investment opportunities as they see fit. Preferred equity can be a source of significant cash flow, especially when purchased in large quantities, as is sometimes the case with institutional investors.
Investors Receive a Percentage of Annual Income
Preferred equity investors may purchase ‘participating’ shares of preferred equity. Participating preferred shareholders receive the normally scheduled dividend and may also receive an additional distribution to ‘share’ in a percentage of the annual income.
For example, let’s suppose that an investor purchases preferred equity that entitles her to an annual dividend of $1.00 per share. In addition, the investor will also receive a percentage of the issuer’s annual income, usually above a predetermined level. If the level for participation is $1 million in annual income, then the investor would receive a portion of the income above $1 million in proportion to her stake (i.e., if she owns 5% of the total outstanding participating preferred equity, then she is entitled to share in 5% of the annual income above $1 million).
Steadier Rate of Return
Many investors, especially institutional investors, are attracted to preferred equity for the steadier returns it provides. Preferred shares are typically not as volatile as common equity shares because preferred equity is higher in the capital structure, so preferred shareholders receive dividend payments before common shareholders. Preferred shareholders also typically enjoy a larger dividend than common shareholders, and preferred dividends are less likely to be reduced or eliminated compared to common stock dividends.
Equity Holders Have Ownership Interest
Regardless of where an investor sits within the equity structure, they have an ownership interest in a real estate project, limited liability company, or whatever type of investment they are involved with. One important point to note when examining the difference between preferred equity and common equity is that common shareholders typically have voting rights, while preferred shareholders do not. This means that preferred equity holders do not get to vote on things like director seats and policy matters. In effect, preferred equity holders are silent partners.
Preferred Equity Cons
Preferred equity has certain disadvantages that investors should be aware of when researching investment options and performing due diligence.
Loss of Capital is a Risk
As discussed above, preferred equity is typically less risky than common equity, but preferred equity can still lose value and result in a loss of capital for the investor. For example, if a large multifamily development project is completed as the economy is going into a recession, the rent roll might not support the expenses needed to run the property. In this case, a preferred equity real estate asset would likely lose value because there is heightened risk that the dividend will not be paid or will be paid late.
Ownership Interests are not Secured
One additional con associated with preferred equity is that preferred equity holders do not have a claim against the underlying assets owned by the real estate entity or operating business. This means that in the event of a bankruptcy, preferred shareholders may not receive ownership in the real estate that is owned by the struggling entity. Preferred equity holders are typically below debt holders on the capital structure, and for this reason, they should not expect residual value to fall to them in the event of a bankruptcy or liquidation.
Typically No Upside to an Increase in Property Value
Preferred equity is typically structured to pay out a fixed dividend that is unaffected by any changes in the value of the underlying property or entity. This means that as property values increase over time, the preferred equity holders do not receive additional dividend payments or see an increase in the dividends received. A very successful commercial real estate project may result in a big payoff for the common equity holders in the way of increasing dividends and share prices, but investors in preferred shares will not see the same dividend increases. Investors interested in preferred shares should be aware of the limited upside to increasing property values and should balance this against the pros of owning preferred equity that we discussed above.
Common Equity Pros
Common equity receives plenty of press and airtime because of its widespread popularity, the potential for high returns and other pros described below.
Highest Internal Rate of Return
Common equity is typically said to have higher returns on average than preferred shares or debt instruments. In fact, common equity is usually viewed as the asset class having the highest potential rate of return.
No Cap on Potential Return
Many investors consider the best thing about common equity investments to be the fact that there is no cap on the potential return. This means that common equity can increase in value indefinitely. Many of the best investments in history have been common equity investments where through great insight, fortune, or a combination, the investor profited in a truly life changing way. This is a feature fairly unique to common equity because many other asset classes and financial instruments have limited upside, such as bonds. Many investors are drawn to equity because it is the one asset class that can continue to increase in value over the long-term.
Upside to Property Value Increases
Equity investments in commercial real estate come with the benefit of experiencing upside as property values increase. This means that over time the investor’s wealth grows along with the increase in property value that occurs through the natural course of the economic growth cycle. In some cases this can be a huge advantage to the equity holders. Everyone has heard stories of real estate markets that have gone through renaissance-style turnarounds where the property owners made windfall profits as a result. This is only possible through equity ownership where the large increase in property values due to the increased desirability of the area results in the equity stakes growing in proportion. Many of the savviest commercial real estate investors spend a lot of time and effort searching for opportunities like this because they know the power of property value growth to create wealth.
Opportunity for Longer Term Growth and Profit
We just saw how equity investments have unlimited upside potential and tend to increase along with property values. For many investors this is the holy grail of commercial real estate investing, and many investors have found that the increase in equity value associated with an increase in the property value ultimately allows them to retire, purchase a dream home, or put their children through college. In addition, some common equity shares pay dividends, which can also increase over time if the venture performs well. When the time comes to sell an equity stake in a commercial property, the investor can use various strategies to achieve their goals. One of the most popular is known as a 1031 Exchange because it allows the investor to defer taxes indefinitely as long as all applicable rules and regulations are followed. 1031 Exchange strategy is definitely a topic worth learning about, and we have written extensively on it. Click here for an example.
Common Equity Cons
We have noted the major benefits associated with common equity, but there are also drawbacks that investors should be aware of when deciding where they want to invest in the capital structure.
Paid After Preferred Equity Holders
In the event of a bankruptcy or liquidation, common equity holders are the last to receive a payout among the other investors in the capital structure. This means that bondholders and preferred equity holders will receive any residual value that is leftover once the liquidation or foreclosure proceedings wrap up. It is often the case that common equity holders do not receive anything from liquidation proceedings, which means that they would experience a complete loss of capital. It is important for investors interested in common equity to consider the risk associated with losing most or all of their principal in the event of a bankruptcy.
Risk for the Highest Potential Loss
We have already explored the unlimited upside associated with common equity. It is probably even more important for investors to understand that common equity comes with the highest potential for loss among any position in the capital structure. Common equity typically experiences the largest swings in value, which is known as volatility. In order to be a successful equity investor, it is important to be prepared for these swings, which can be quite large and occur in a short period of time. Equity investors are also take more risk of total loss than the other positions in the capital structure because common equity holders are the last to receive a payout in a bankruptcy situation as we touched on above.
No Secured Ownership Interests (Same as Preferred Equity)
The last con associated with owning common equity is the lack of a secured ownership interest. This means that common equity holders are not entitled to any collateral, whether physical or financial, in the event that the issuer cannot make dividend payments or even in the event of a liquidation. For contrast, bonds are sometimes collateralized by a physical asset or a financial stake. For instance, if a company is unable to make an interest payment, the bondholders may have the right to receive real property as compensation. This is not the case with common equity because it is an unsecured asset class. Investors should consider the additional risk of owning common stock without a secured ownership interest when deciding on where to invest in the capital structure.
Is a Preferred Equity or Common Equity Investment Right for You?
Deciding between investing in preferred equity and common equity is a very personal decision that should be made only after fully understanding and considering the risks and benefits of each. Many successful investors choose to allocate capital to both depending on their risk tolerance, goals, and diversification needs. Individuals interested in either asset class should consult a professional financial advisor for guidance on risks, investment strategies, and tax considerations.
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If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or firstname.lastname@example.org.