Preferred equity – another way to invest in real estate

What is preferred equity?

Real estate developers or owners (I'll refer to them as project sponsors) want to increase their leverage. Preferred equity helps them do that by financing a project with capital that is junior (lower priority) to the mortgage debt but senior (higher priority) to the equity the project sponsor already has in the project.

Normally, real estate lenders will not loan in excess of 80% of a property’s value. This is because the lender wants to give themselves some cushion of protection if things go wrong. These first-position loans are typically more in the 60%–70% range.

In the real estate investing realm, mortgages are often referred to as senior debt. This is a financing position that: (1) is acquired privately from a mortgage lender, (2) is not bought, sold or traded on the stock exchanges and (3) has no central rating system.

So while senior debt gets the real estate ventures funded most of the way, the project sponsor will sometimes need more money to finance more of the deal. That’s where preferred equity comes into play.

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Preferred equity fees & risk

Preferred equity is more expensive than senior debt. It's also riskier for investors. It’s more likely to be adversely affected if the property’s value decreases. So the interest rates paid to investors are higher to compensate for the added risk.

Often, project sponsors seek even more financing by offering common equity positions. This is the least secure (riskiest) but most lucrative position for investors. Lenders and preferred equity financers get favorable interest rates, but if the property has increased in value, it’s the common equity position investors who get to reap those (often greater) rewards.

These rewards often include:

• Share in gains from property appreciation;
• Rental income distributions; and/or
• Benefits from potential tax deductions such as depreciation.

The real estate capital stack

Real estate professionals use the term “capital stack” to describe the layers of money and the rights that are attached to each layer. As you move “up” the capital stack from debt to equity, you enter zones of increasingly higher risk — but also potentially higher rewards.

Typically, the capital stack looks something like this:

As you can see, the bottom layer of the capital stack is the bank or mortgage holder that has to be paid no matter what. Their investment in the venture is secured by the property itself. The highest risk and potentially higher reward from the venture goes to the project sponsor. If they don’t keep up with payments, the lender may foreclose on the property and take away everything that the sponsor/borrower has worked for.

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Preferred vs. common equity

Preferred equity investors favor a fixed return and priority as to both the return of their investment and the return on their investment. This is particularly true of institutional investors.

Typically, preferred equity has contractual rights contained in the project’s operating agreement. Preferred equity also avoids the need of an inter-creditor agreement with the senior lender and enjoys a better position in any bankruptcy scenario.

Like debt, preferred equity most often involves a fixed term. This is usually two to three years. At the end of the term or in the event of certain triggering events related to the nonperformance of the sponsor, the sponsor is typically required to redeem the preferred equity interest for a redemption price equal to the unreturned capital plus any accrued but undistributed interest earnings.

Common equity, on the other hand, is more than just a loan. It is buying into the project. An investor receives a percentage interest in the project. That way, she receives a part of any increase in the value of the completed project. Or she might receive a portion of rental income. Or both. This is pretty much like buying stock from your broker. You own a portion of the company. But if the project loses money, the investor may also lose her money.

The most common differences are detailed in this chart:

table goes here

Note: While the terms defined in this chart are common differences, each real estate crowdfunding site seems to have its own definition of each. On some, preferred equity is referred to as “mezzanine,” for example. There are hybrids of each type of equity as sponsors and loan officers are free to set priorities as they see fit for any deal. You will need to read the specific deal documents carefully before investing.

Preferred return is not the same as preferred equity

Although the two are often confused, there is an important difference between preferred return and preferred equity. Preferred equity is a position in the capital stack that has repayment priority. Preferred return refers to profit distribution. Profits from operations, sale or refinance are distributed to one class of equity before another. The difference is that preferred return is a preference in the returns on capital, while a preferred equity position is one that receives a preference in the return of capital.

Crowdfunding options

There are many crowdfunding sites that offer preferred equity investments with varying definitions and projected annual returns.

• At Fundrise, preferred equity investors are given preference over common equity investors in the distribution of cash flows. Profits are paid back to preferred equity investors (after all debt has been repaid) until they receive the agreed-upon “preferred return.” The remaining distributions of cash flow are returned to common equity holders.
• RealtyMogul distinguishes between mezzanine debt and preferred equity. Both represent higher potential upside returns… and potential downside risks. The platform offers both types as options for diversifying your real estate portfolio “across the risk spectrum.”

This is a testimonial in partnership with Fundrise. We earn a commission from partner links on Moneywise. All opinions are our own.

Summary

Preferred equity offers investors a more secure, less risky equity position than common equity. And as with any investment, the higher the risk, the higher the projected return.

Both common and preferred equity can be advantageous for both real estate companies and investors. Real estate companies (project sponsors) can increase their leverage — and thus their potential returns — by financing their projects beyond the mortgage by offering preferred equity. This is junior in right of payment to the mortgage debt but senior to the sponsor’s equity. Investors can gain higher returns in exchange for taking on higher risk, a position just one level lower than a first-lien mortgage.

The frustrating reality is that this terminology is used interchangeably — and not defined by any regulatory agency. So what one crowdfunding platform calls “preferred equity,” another may call “mezzanine debt.” And how one platform defines preferred equity and common equity can differ substantially from another platform. And even on the same platform, there seem to be nuances in what the terms mean from one deal to the next.

This article is intended to introduce you to the terms you’ll see, but please remember to read all documents carefully and make sure you thoroughly understand what you’re investing in before you plunk down any of your hard-earned money.

Regardless of whether you’re investing on a crowdfunding platform or directly in a deal, always do your due diligence.