Preferred equity is a component of the capital stack for financing multifamily investments that may or may not be used depending on the present market conditions, the amount of common equity available, and the investment strategy of the sponsors.
So what is the purpose and function of preferred equity?
First we need to briefly define the capital stack, as it is difficult to discuss preferred equity without becoming familiar with the other layers of the stack as well.
Understanding the capital stack is crucial if you want to be involved with large real estate purchases or developments.
The capital stack is the total invested capital in a real estate investment. The layers of capital stack on top of one another in the order in which those sources of capital are repaid.
The lower the capital source is within the stack, the higher priority they are to receive payments from the asset. The higher layers of the stack typically receive higher returns to account for this.
It is important to keep in mind that preferred equity is not always or even commonly used in a real estate syndication.
You might not have run into it on the investment opportunities you’ve reviewed, but will likely cross paths with an investment that includes some preferred equity investors sooner or later.
If you’ve never encountered preferred equity in the wild before, you’re likely to end up a little confused in that situation.
The goal of this article is to explain preferred equity ahead of time, so you’ll know what you’re looking at if you do come across it in an investment offering you are reviewing.
We typically do not utilize preferred equity as we like to put our own investor base as the highest priority, which we will explain shortly.
For a simple transaction like buying a duplex, the stack will likely only include the debt acquired from the bank at the bottom of the stack and your own cash as the only source of equity at the top of the stack.
When you’re purchasing assets that cost millions or even tens of millions of dollars, however, there are more parties involved in the stack in order to make the purchase possible.
A typical capital stack may include senior debt at the bottom of the stack, followed by mezzanine debt if that is being used, followed by preferred, then common equity. You may be wondering what all of these classifications mean.
Senior debt:
This is your “traditional” debt that you would acquire from a bank or other lender, typically for the bulk of the property value (up to 80%) in multifamily transactions.
Check out our 10 Things You Need to Know about Multifamily Financing article for a more complete overview of this topic. Senior debt is always at the bottom of the capital stack.
Mezzanine debt:
This form of debt is used to fill gaps in financing.
For example, if senior debt has been secured for 70% of the asset value and the sponsor has pledged a combination of his/her own capital with their investor capital to account for 20% of the equity, the remaining 10% could be filled by mezzanine debt.
In return for filling these gaps, mezzanine loans charge the borrower a higher rate of interest than traditional debt financing.
Because the property itself is already pledged to the senior lender in the event of a default, the mezzanine lender has an interest instead in the equity position of the sponsor.
Mezzanine debt occupies the next position after the senior debt, giving it priority over all form of equity. See our What is Mezzanine Debt for Real Estate Investing? for additional information.
Common equity:
Like senior debt, this is your “traditional” form of equity that you are likely already familiar with. In a real estate syndication, both the general partners and limited partners are common equity holders.
The limited partners will typically have a preferred return, meaning they are higher in priority than the general partner to receive their preferred amount, but ultimately both groups are still holders of common equity.
The limited partners simply hold a different class of common equity than the general partners that entitles them to a higher priority in receiving cash distributions via their preferred return rate.
You can read our What is a Real Estate Syndication for Multifamily Investing? and What is a Preferred Return in Real Estate Investing? articles for more on these topics.
Preferred equity:
This is a second form of equity that has higher priority than common equity within the capital stack. In today’s article, we’re going to discuss what preferred equity is, as well as some of the pros and cons of using it in a real estate transaction.
Preferred Equity is like the Equity Version of Mezzanine Debt
Similarly to mezzanine debt, preferred equity is usually acquired to fill gaps in financing for multifamily transactions.
Whereas with mezzanine debt, the debt is secured by sponsor’s equity stake in the property, for preferred equity, the mechanism is the ability to compel or take control of the property in order to sell in the event of a default.
Both preferred equity and mezzanine debt usually come with a higher cost of capital than their traditional cousins.
Preferred equity holders will often receive both a preferred return as well as some share in the upside at the time of a sale or refinance.
This hybrid product provides the preferred equity investors with a healthy return with minimized risk due to the superior position in the capital stack.
Joint Venture Structure
A common way of structuring a preferred equity investment for a real estate syndication is to use a joint venture structure. The way this works is the real estate syndicate enters into a joint venture agreement with the preferred equity investors.
For example, say that you are a sponsor/general partner in a real estate syndication company. You have an upcoming investment opportunity and want to use a combination of your own investors and a preferred equity investor group.
The first step would be to form a normal real estate syndication. The general partners call on their passive investor base and whoever is interested in the opportunity invests their capital and becomes a limited partner in the deal.
When preferred equity is in the mix, the next step would be for the real estate syndicate itself (the general partners and limited partners together in their combined capacity as the “syndicate”) to form a joint venture agreement with the preferred equity investor group.
The reason why you might want to do this are varied. Some sponsors prefer to work with a single investment group rather than a lot of investors.
There is also a strategical advantage that could be gained through capital stack diversification. Preferred equity investment terms are often shorter than the hold period of a syndication, allowing the syndicate to pay out and divest the preferred equity group in year two, for example, of a planned seven year hold period.
An example of where this strategy might come into play is a value-add opportunity with a cash-out refinance planned at stabilization at the end of year two.
The preferred equity investors serve a critical role in the early stages, but then exit from the investment prior to the common equity investors, freeing up cash flow to the limited and general partners.
Components of Preferred Equity Investments
The main feature of preferred equity is it occupies a hybrid position in the capital stack that allow it to share in some of the benefits of equity investment through cash flow distributions and a share in the profits during a capital event, while also minimizing risk by occupying a superior position in the capital stack and having some other downside protections, as well.
Cash Flow💰
Preferred equity investors share in the cash flow distributions.
In fact, their share of the distributions is higher priority than any other equity investors. This is typically paid out via a preferred rate of return.
Do not be confused by the fact that both the limited partners and the preferred equity investors receive a preferred rate of return.
The way it works is that the preferred equity investors are simply “even more” preferred than the limited partner investors.
This is why we don’t usually involve preferred equity investors in our own offerings.
We want to keep our own investors as the top priority in every investment we make.
Let’s say that both the preferred equity investors and the limited partners have a 8% preferred return. The preferred equity would be distributed cash flows up to their 8% first.
Once that 8% for the PE is met, distributions towards the limited partners begin until their own 8% threshold has been reached.
It is not until both those groups have both been compensated in order before the general partners receive any distributions.
Capital Event Upside 📈
The preferred equity investors will typically also share in the upside at the time of a sale or refinance, but this will usually be capped and have less total profit potential than the limited and general partners.
For example, a typical split for profits at the sale of the building between the general and limited partners might be 40% of profits to the GPs and 60% of profits to the LPs.
This is just a percent split of the profits with no cap to the amount the investors could potentially receive.
For preferred equity investors, you’re more likely to see a preferred return on the sale than a generous split like that.
For example, the equity investors could have a preferred return of 8% at the time of sale or refinance.
Once you’ve paid them that amount, they aren’t entitled to any profits exceeding their threshold. This is the advantage that the limited and general partners in a syndication have over the preferred equity investors.
Pros and Cons of Preferred Equity
Pros
1. As the general partner in a real estate syndication:
For the general partners in a syndication, preferred equity serves as a method of diversifying the capital stack and potentially staggering the exit periods of the two groups of investors. This doesn’t have an obvious tangible benefit as a general rule of thumb, but depending on the nature of the investment itself, this might be advantageous to the members of the syndicate (both general and limited partners) in certain circumstances.
2. As the general partner in a real estate syndication:
The other main example of when preferred equity would be used is the general partners simply do not have a sufficiently large investor base to draw from and have a gap in funding. There are always larger purchases out there and if you find a great opportunity that requires preferred equity to fully fund, then it can be a no-brainer and a great option for you.
3. As the preferred equity investors:
The preferred equity investor groups like this structure because they hold priority over the equity investors, enjoy some of the protections of debt providers in the event of a default, and have some ability to share in the profits of sale. It’s a pretty good deal for them!
Cons
1. Performance Requirements:
If there are any sports fans in the audience, you might be familiar with incentive contracts that can reward or penalize a player for meeting certain goals over the course of the season.
Similarly, preferred equity providers often have a number of minimum performance levels you must meet as the general partner in order to avoid defaulting on your obligations to them.
Some examples of these include minimum occupancy rates or regimented budget compliance rules.
2. Misalignment of Interest:
The interests of the preferred equity investors and the limited partners are often at odds with one another.
An aggressive preferred equity group could use bogus performance requirements to force an early sale at the expense of the limited partners.
We like to keep our own investor base as the highest priority and avoid using preferred equity investors for this reason.
3. Over-Reliance on Single Source:
It can be risky to be overly reliant on a single large source of capital as a real estate syndicator.
It’s better to have a wide pool of investors vying to get in to your deals, even if each investor has less capital than a whale preferred equity group might have access to.
If you rely on a single source, it’s much easier for you to get caught holding the bag with no other alternatives if your preferred equity source pulls out at the last minute.
Conclusion
We typically do not use preferred equity because it introduces a class of investors with more advantages than our own investor base, which doesn’t sit right with us.
We would rather have those individuals who have sought us out as investors to receive the greater rewards and not the other way around.
That said, preferred equity can be extremely useful if an opportunity comes along and you require the additional capital.
It’s also important to be aware of the existence of preferred equity if you are a passive real estate investor.
Obviously a deal with a preferred equity source will behave quite a bit differently than one without any preferred equity involved.
You can go in to new opportunities armed with a more complete understanding of how preferred equity might impact your bottom line.
