Institutional grade commercial real estate assets are very expensive. Purchasing one often requires cobbling together an assemblage of capital from various sources.
Most investors are familiar with the two most common sources: debt and equity. But, there are others, one of which is called “Preferred Equity.”
In this article, FNRP explains what is preferred equity in commercial real estate, an example of the preferred equity investment structure, and an analysis of the safety of preferred equity real estate investments.
What is Preferred Equity?
Preferred equity is the most senior equity holder. A preferred equity investment is secured by an interest in the entity that owns the property, rather than the real estate property itself.
But, in order to understand what preferred equity is and how it works in real estate, it is first necessary to understand the concept of the “Capital Stack.”
What is the Capital Stack?
Capital Stack is the term used to refer to the collection of capital used to purchase a commercial real estate asset. Depending on the transaction, there can be up to four components:
1. Senior Debt
An easy way to think about senior debt is as the loan received from a bank or lender. It is collateralized by a first position mortgage on the property being purchased.
2. Mezzanine Debt
If there is a gap between the amount of senior debt that a lender is willing to provide and the amount of equity that can be raised for a property, it may be filled with Mezzanine Debt, which is “subordinate” to senior debt.
3. Preferred Equity
Preferred equity is the most senior equity holder. A preferred equity investment is not secured by the real estate property itself, but by an interest in the entity that owns the property. This is a riskier position and investors require a higher return.
4. Common Equity
Finally, the investors with the most junior claim on property cash flow are the common equity holders. Like preferred equity holders, their claim is not secured by the property itself, but by shares in the entity that owns the property. However, the claim is subordinate to preferred equity holders. Generally, common equity carries the most risk in the capital stack so investors require the highest return.
Not every transaction involves every component. But, the most complicated transactions could. For this reason, it is important to understand each component and the rights that come with it. To accomplish this, a direct comparison is helpful.
Senior Debt vs. Preferred Equity
Within the context of real estate investing, there are several key differences between senior debt and preferred equity.
Claim on Property Cash Flow
First, the senior lender has a first claim on property cash flow, which makes it the least risky position in the capital stack. Preferred equity is “subordinate” to all debt holders, which means their repayment claim comes after all debt has been repaid.
Rate of Return
Second, because senior debt is the least risky position of the capital stack, its rate of return is also the lowest. It varies, but senior debt holders typically achieve a return of 4% – 7% annually with no chance for profit participation. Because Preferred equity carries more risk, it also comes with the chance for a higher return, which consists of regular payments plus some profit participation upon sale.
First Position Mortgage
Third, senior debt is secured by a first position mortgage on the property, which is why the senior debt holder is also first to be paid when the property is sold. Preferred equity is secured by shares of stock in the entity that owns the property, not the property itself.
Foreclosure proceedings
Finally, the senior debt holder has the ability to initiate foreclosure proceedings if the borrower defaults on their loan. During the foreclosure process, the lender takes title to the property and sells it. Proceeds are used to repay the loan. Preferred equity investors do not have this option.
Summary
To summarize, senior debt is less risky, but it also offers a lower return. The holder has the highest priority claim on property cash flow and can initiate foreclosure proceedings if they are not repaid as promised. Preferred equity is a riskier position than senior debt, but has a higher priority claim than common equity investors. Preferred equity offers a chance for a higher return in exchange for the higher risk.
Preferred Equity vs. Common Equity
Preferred equity and common equity are both part of the equity tranche of the capital stack. The key difference between the two is order of repayment.
Claim on Cash Flow
Preferred equity holders have a higher priority claim on cash flow and/or sales proceeds than common equity holders. Their claim comes after all debt has been repaid, but before common equity holders who are last in line.
Potential Returns
This difference in repayment priority also means a difference in potential returns. Preferred equity holders typically receive some regular payment plus limited profit participation. This puts a ceiling on potential returns, which are usually in the 10% – 15% range. There is no such limit for common equity holders. They rely solely on profits, which can be significant if the property is successful.
This repayment order distinction is particularly important in the event of a bankruptcy or foreclosure. The priority of claims can be the difference between receiving an entire investment back or receiving nothing at all.
Preferred Equity vs. Preferred Return
It can be tempting to mistake the preferred equity position in the capital stack with a preferred return that is part of a waterfall. In fact they are two completely different things.
Preferred equity means that investors get preferred distributions that speak to their position in the capital stack.
A preferred return is part of an investment waterfall structure where investors are promised a certain percentage return before the investment manager earns any money.
Are Preferred Equity Real Estate Investments Safe?
Like many things in commercial real estate, the answer to this question is relative. A preferred equity investment is safer than a common equity investment opportunity, but not as safe as senior debt. For each commercial real estate investor, the key is to understand where the investment falls in the capital stack and what repayment order they are entitled to.
Hybrid Return Opportunity
In the case of preferred equity, there is a hybrid return opportunity. Depending on the specifics of the deal, investors are entitled to a flat annual return plus an equity “kicker,” which entitles them to some portion of the upside if the property is sold at a profit. Absent profit participation, preferred equity investments typically return 7%-12% annually. But, this can increase to 15% with the equity participation factored in.
Given these features of a preferred equity investment, the question isn’t so much “is it safe?” The better question is, “does the risk/return profile of the preferred equity tranche match the risk tolerance and return expectation of the individual investor?”
Example of a Preferred Equity Investment Structure
For many commercial real estate deals, the exact composition of the capital stack is somewhat of a non-issue as long as the deal performs well. However, it becomes critically important when the deal underperforms and slips into foreclosure or bankruptcy. To illustrate this point, consider the following simple example.
Assume that an investor has identified a multifamily property they would like to purchase for $10,000,000. They form a limited liability company and work with a senior lender to obtain a senior loan for 60% of the purchase price ($6,000,000). Of the equity that needs to be raised, $2,000,000 comes from preferred equity, and $2,000,000 comes from common equity.
At first the property performs well, but after some time it runs into trouble and the lender forecloses on it. In a forced sale, they are able to get a price of $8,000,000. This is where the claim order of the capital stack becomes very important. The lender has a “senior” claim so they are repaid first, Assume it was an interest only loan so they are repaid the full $6,000,000. Of the two groups left to be repaid, the preferred equity holders are ahead of common equity holders so they get their money back in full as well, $2,000,000. There is nothing left for the common equity holders and their position is a total loss.
Conclusions & Summary
- Preferred Equity is a class of ownership interest in a commercial real estate property and it is secured by shares of stock in the entity that owns the property. In terms of risk, it is considered riskier than senior debt, but not as risky as common equity.
- Preferred equity holders typically earn a flat annual return plus some sort of “equity kicker” which entitles them to profit participation in the event the property earns one upon sale. All in, preferred equity investors typically achieve returns in the 10% – 15% range.
- Rather than purchasing a property outright, investing in preferred equity can be a viable alternative when a correction feels imminent. In such a case, investors could still earn their flat return, but have some level of downside protection by virtue of their priority repayment rights.
- Real estate investors that are considering a preferred equity financing investment should always perform a significant amount of due diligence on the property, the market, and the offering itself. The preferred equity structure and repayment can vary from deal to deal so investors should also pay close attention to the operating agreement to ensure they fully understand how the investment works.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
