📈Preferred Equity: The Basics

Here's my preferred topic for this Saturday - Preferred Equity

If you are in the commercial real estate space, chances are you have heard the term preferred equity. It's becoming increasingly more popular.

But what the heck is it?!

Preferred Equity Simply 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.

Feel free to reply directly to this email if you have any questions!

Real Estate Terms Defined

Did you enjoy this newsletter? The best compliment would be for you to share this on social media or with a friend.

Please share this link:

📈 Modeling Your Success,

• Analyze Your Next Deal in 10 Minutes or Less 

• Free Acquisitions Checklist

• Miss Last Week's Newsletter? Read Here

• Private Facebook Community