📈Preferred Equity 101

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Author

Justin Goodin
December 09, 2023

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Preferred equity is a form of equity that can be structured into a commercial real estate project as a way to create an investment that, ideally, strikes a balance (both in risk and reward) between senior debt and common equity.

In this newsletter, we’ll explain where preferred equity fits into a real estate transaction, discuss its characteristics, and highlight some of the pros and cons investors should consider when evaluating a preferred equity investment.

Preferred Equity Defined:

Preferred equity (PE) is the layer of a capital stack that sits in between common equity and the senior debt (or sometimes Mezz). Since we always read the capital stack from the bottom up, we can see that senior debt is always paid first, then preferred equity, and then finally common equity.

Often PE investors are providing a large chunk of equity, and therefore, want to get paid first (preferred position) before the common equity. By getting paid first, the PE provider is in a less risky position compared to the common equity investors.

PE is interesting because it has characteristics of both debt and equity. Meaning, preferred equity often gets paid a fixed rate of return (like debt) but can also still earn tax and depreciation benefits (like equity).

Why Sponsors Use Preferred Equity

PE equity acts as additional proceeds to your deal, therefore it can increase your leverage on the deal. For example, if your lender is willing to provide you with 70% LTV debt, a PE partner can provide a chunk of equity (which acts like debt) to increase the leverage overall. So now, your leverage could be 80%.

Again, since the PE investors earns a fixed rate of return, the sponsor and the common equity investors earn all of the upside. For example, let's say you agree to pay a PE investor 8% on your next deal. In 5 years, you sell the deal for an absolutely amazing price way above your projections. You still pay the PE investor their 8% and nothing more. You and your common equity investors will benefit from all of the upside. Not bad right?

Soft Pay Vs Hard Pay

Below, I will be referring to what is known as the current pay distribution, meaning the cash distribution paid (either monthly or quarterly).

  1. Soft Pay - You pay the PE investor an agreed upon return. Let's say 8%. If the project does not allow you to provide the 8% return or you miss a payment, the PE investor is not able to take control of the deal and the payment accrues to the next year. However, there may still be consequences for missing the payment.

  2. Hard Pay - You agree to pay the PE investor 8% on distributions. By missing this payment, this would trigger a default and would allow the PE investor to exercise certain control rights.

Conclusion

Those are the basics of preferred equity and why it's used. Of course, there are pros and cons to using PE. It can be an amazing tool for some real estate transactions but definitely not best suited for every deal.

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