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Preferred equity is a unique method of financing commonly used in large commercial real estate projects to increase the leverage for sponsors or syndicators — which are groups of investors who pool together their funds to purchase real estate — and create a great investment opportunity for individuals looking to earn consistent returns at a significantly reduced risk.
Preferred equity can be a decisive advantage for both sponsors and investors alike. Let’s go over how preferred equity works and the solutions it can provide.
What is preferred equity?
Preferred equity serves as additional capital for active investors to fund a real-estate transaction.
This type of equity has a high priority in the capital stack and is superior to common equity, sitting right behind senior debt. When profit comes in, or in the event of default, the senior debtholder receives payments first, followed by preferred equity and, lastly, common equity.
An example of preferred equity in real estate
An example illustrates this concept best. Suppose a real-estate syndication is looking to acquire a building for $50 million. The bank is willing to loan up to 70% of this purchase price. As such, the bank puts up $35 million, which leaves $15 million to raise.
The sponsorship team of the real-estate syndication can raise $10 million from investors, leaving $5 million left to raise to close the deal. There are two options. The first could be to secure mezzanine financing, like a second mortgage. But that can be very challenging to find at a reasonable rate and will likely come from a bank.
Another choice is to look for $5 million in preferred equity. Perhaps the syndicate could sell $5 million in preferred equity with an 8% annualized return on investment. That might be lower than a lender but high enough to attract family offices, other real-estate syndication companies or institutional investors to bring in the necessary capital to acquire the asset.
By bringing in preferred equity, the real estate deal can now go through with three entities on the capital stack:
1. Senior lender ($35 million)
2. Common equity ($10 million)
3. Preferred equity ($5 million)
As outlined earlier, the senior lender has priority for payments, followed by preferred equity and common equity (the general and limited partners). This means that before common equity investors can receive a penny of profits, preferred equity investors must be paid in full.
Why do investors and sponsors opt for this equity type?
Preferred equity for investors
For investors, preferred equity features a few benefits. It’s a more secure, stable investment with a fixed rate of return. So, if you’re an investor with $100,000 ready to go and are happy making an average return of 7-12% on that investment, preferred equity could be the way to go.
A downside when it comes to preferred equity investing is the lack of upside potential. If a real-estate project performs well, preferred equity investors will continue to receive an agreed-upon fixed rate of return on their capital with no share of the upside of returns.
Preferred equity for sponsors
For sponsors, preferred equity can be more an accessible way to raise money than taking on new debt or finding new limited partners. Senior lenders and mezzanine loans are genuine debt instruments where the lender has a lien on the property. As such, these loans mostly come from financial institutions.
Preferred equity, on the other hand, can come from anyone. A family office, hedge fund, real-estate syndication company, venture capital fund or even a private individual can buy preferred equity. That opens up a whole new world of potential investors that you might not reach with just debt and common investors, and it’s generally less expensive than senior debt or carving out another sponsor or manager (GP) position.
Preferred equity can benefit investors and sponsors
Ultimately, preferred equity can be a decisive advantage in a real-estate syndication because it provides another, more flexible way to raise money. Instead of being limited solely to limited partners and lenders, a real-estate syndication can open a whole new world of prospective investors looking for preferred equity investments.
Many of these investors don’t want to take on all the risk of a project, nor do they want to issue a loan backed by some asset. Instead, preferred equity is perfect in this regard — investors get paid a stable return, have no involvement after writing the check and have more security than common equity shareholders.
Whether you’re investing in a commercial transaction or raising funds, take a look at this type of equity investment and consider whether or not it can help you achieve your financial and real-estate goals in 2022.