Finding ways to passively earn a return that reduces risk exposure is the goal of every investor whether you're placing money in the stock market or in a private fund or crowdfunding opportunity. Preferred equity is a special financing structure that is common among large commercial real estate investments or private equity funds which can provide participating investors with additional security on their investment while providing the active investors leverage to more capital for an investment.
If you're unfamiliar with the term "preferred equity" or how it's used in real estate, continue reading to find out what preferred equity is, how it works, and how it differs from other lending structures.
What is preferred equity?
Preferred equity is a type of capital structure that places a private lender in a priority position for repayment from any cash flow or profit earned from a particular investment over others. Their preferred equity position places them behind the repayment of a senior lender such as a first or second mortgage from a traditional bank or lending institution but in front of other participating investors or sponsors.
Similar to preferred stock, this preferred equity security reduces some risk exposure for the preferred equity investor because it places greater importance on the repayment of their debt above common shareholders or common equity investors. The preferred equity investor earns preference shares, which typically have a higher rate of return than other lenders because they are at a slightly lower lien position than senior debt holders, which carries a higher level of risk.
How is preferred equity used in real estate?
Preferred equity financing is most commonly used with large real estate investments where additional funds are needed beyond what a senior debt like a bank will or can provide. Rather than borrowing the additional funds from one or a few investors in the form of a loan that holds a second or third lien position, they offer preferred equity positions to equity investors. In the financial world, the multiple layers of capital are referred to as a capital stack, because the borrower or sponsor is stacking different financing terms and priority positions on top of each other.
Example of preferred equity structure
Most preferred equity structures are fixed rates of return for a specified period of time, which could be one year to five years or more. Since most commercial loans are for shorter terms, five to ten years, it's likely the sponsor will refinance or liquidate the property repaying all debt including equity investors in a period of ten years or less. Some preferred equity structures will include a percentage of shared equity in the property, so if and when the property appreciates and the asset is sold, they earn a percentage of the gained appreciation earned in liquidation.
The easiest way to understand this is to look at a hypothetical but common example of a capital stack that uses preferred equity. Let's say an investor is looking at purchasing a value-add apartment complex for $2 million. The investor in this scenario is called the sponsor because they are doing the work and sponsoring the investment, overseeing the contractors, property managers, and ensuring the investment is completed as intended.
Because the property is underperforming, there's an estimated $350,000 in additional capital needed for renovations and holding costs while the property is being improved and re-leased. The sponsor is able to finance the property with a traditional lender, putting 20% down plus financing fees and due diligence costs (estimated $30,000), bringing their upfront investment need to close and execute the investment as intended to $780,000.
The sponsor puts $100,000 of their own money into the investment but still needs to raise $680,000. They decide to use a capital stack offering a preferred equity investment, paying the preferred equity investors an 8% return from any cash flow or revenues after the senior debt holder (the bank) and before they take any income.