Every year, scores of high school seniors apply for college. Once they receive that fat admissions envelope for the college of their choice, their next challenge, assuming they didn’t get a full ride scholarship, is to figure out how to pay for the four years ahead of them.
I remember back in high school, when I was in the process of applying for colleges, I had a lot of moving pieces when it came to pulling together the tuition money I would need.
Spoiler alert, I did not receive a full ride scholarship, so I had to get resourceful. I had some money I’d saved over the years, plus a few scholarships and grants I’d received. Add to that a partial scholarship from the school itself, and I was most of the way there.
However, I was still several thousand dollars short, even when accounting for additional income from a summer job. As such, my choices were to defer and thus enroll at a later date, or to choose a more affordable state school, which was not my top choice.
Luckily for me, my parents swooped in to help, ensuring I didn’t have to make that difficult decision. They came in and provided me with the extra funding to fill the gap, which enabled me to go to the school of my choice without delaying enrollment.
This “gap funding” is not just something that’s needed for college education, but it’s something that’s extremely valuable and important when it comes to real estate investing as well, particularly in the current lending environment.
In real estate, this gap funding is often provided via something called preferred equity. In this article, we’ll talk about what preferred equity is, how it works in real estate deals, the opportunity in the current landscape, and why you may want to consider investing in preferred equity real estate.
What Is Preferred Equity?
Preferred equity (aka, pref equity) can be an important part of the overall capital stack for a commercial real estate deal, especially when there’s a gap between the investor capital and the senior loan.
When a commercial real estate property requires tens of millions of dollars in upfront capital to close on the acquisition, there may need to be multiple sources of capital, including the senior loan, sometimes additional debt like a mezzanine loan, common equity from investors, and sometimes preferred equity.
Preferred equity, as its name implies, provides real estate investors with a preference or advantage over common equity. Preferred equity, like mezzanine debt, sits behind the senior loan but ahead of common equity. That means that, in a capital event, preferred equity investors would get paid out ahead of other investors.
Not every deal requires pref equity, especially when there’s no funding gap. However, when there’s a gap between the amount of committed / available investor capital and the amount needed to close the deal, that’s when preferred equity becomes a critical tool in the toolbelt.
In the current economic landscape, as lending restrictions are tightening, it’s becoming more and more important for syndicators to seek creative financing solutions like preferred equity. To dive deeper, let’s take a look at two quick examples, to better understand the basic concept of pref equity.
Real Estate Preferred Equity Example #1 – New Acquisition
Let’s say that a real estate syndication was in the process of acquiring a multifamily asset for $20 million. The lender is willing to loan $12 million, which means $8 million is required as a down payment (this is not counting the additional capital needed for reserves and property improvements).
Let’s say that the syndication group has raised $5 million from their investors. However, this still leaves a $3 million gap. Rather than seek a second loan, the syndication group could instead offer a preferred equity investment (or bring in a preferred equity group), which would sit between the senior loan and the investor equity.
Typically, preferred equity offers different terms than other investor equity classes, but the main advantage is that pref equity sits higher in the capital stack, which lowers the overall risk of the investment.
Real Estate Preferred Equity Example #2 – Refinance
A more common scenario, particularly in the current lending landscape, is a gap in the funding needed for a refinance.
Let’s say that a syndication group purchased a property for $30 million two years ago. That property might be valued at, say, $25 million in today’s market, so they don’t want to sell. However, the rate cap is expiring, meaning debt payments could go up by hundreds of thousands of dollars per month, a very scary proposition that could leave them exposed to a ton of risk.
So, the group is seeking a refinance. The only thing is, because of the current valuation and tighter lender restrictions, they would need to put in an additional $2 million. They are not confident their investors would put in additional capital, and they don’t want to do a capital call.
So, instead, they opt to bring in preferred equity. They might put together a separate pref equity offering, either for their existing investors or via another group of investors.
This pref equity allows them to fill the gap they need, enabling them to successfully complete the refinance, protect against rising interest rates, and hence continue the strong operations of the asset.
Everyone wins in this scenario. The lender mitigates the risk of the syndicator defaulting on the loan and the lender having to take over the property (something the lender definitely does not want to do).
And, the preferred equity investors are able to invest in an asset with strong ongoing performance, secure a prime spot in the capital stack, and get reliable ongoing fixed returns. Win-win-win!
The Preferred Equity Position In The Capital Stack
A key advantage of preferred equity is that it sits in a prime position in the capital stack, ahead of other investor equity. This means that preferred equity gets paid out first.
Let’s take a look at the order of a typical commercial real estate capital stack, so you can see where preferred equity fits in.
The line leader – the first position at the top of the capital stack – is the senior loan. For commercial real estate, this can often be a Fannie Mae or Freddie Mac non-recourse loan that puts in the majority of the capital needed for the real estate acquisition.
The senior loan is a form of debt, meaning that the lender does not own the real estate asset and hence does not get any of the upside. However, the tradeoff is that the lender mitigates their risk because they get paid first, before everyone else.
If the senior lender does not receive their monthly debt payment to cover the interest and/or principal, that can trigger a borrower default, which gives the lender the ability to take over ownership of the underlying real estate property.
So essentially, the senior loan is the head honcho, the big boss. And you don’t want to mess with the big boss.
If a syndication chooses to bring in a secondary form of debt like a mezzanine loan, this becomes the junior loan. The mezzanine loan sits behind the senior loan but ahead of all equity investments – including both common and preferred equity.
Because the mezzanine debt sits behind the senior debt, this gives it a bit more risk. To offset that risk, the mezzanine loan often comes with higher terms than the senior loan and is often secured by ownership shares of the property.
Next in line is pref equity, if the deal includes this piece. Remember, not every deal includes pref equity; it’s used as an instrument when needed, to fill the funding gap.
Pref equity investors get paid after debt payments, but they’re first in line as far as equity. Preferred equity typically receives higher yield when compared with debt.
And, because pref equity sits ahead of other investor equity, the risk is lower. However, even though pref equity gets paid first, it doesn’t receive as much of the upside as most other investor classes.
Just behind pref equity is common equity, which is the category most of the limited partner (LP) investors in a real estate syndication fall under. Even though they may be further back in the line to get paid, these investors stand to gain the most upside from the investment.
For these investors, it may make sense to take a position further back in the capital stack in order to have the opportunity for higher overall returns and growth, as well as significant tax benefits (which preferred equity investors may not receive).
Preferred Equity In Today’s Lending Environment
Due to the perfect storm of rising interest rates, maturing rate caps on floating rate debt, and tightening lender restrictions, more and more syndication groups are finding themselves in a bit of a pickle, which provides a unique opportunity for preferred equity.
More and more syndicators are finding themselves in a position of having secured floating rate debt a few years ago with a rate cap, but that rate cap is expiring, which could open up substantial risk for the investment.
Doing nothing would mean that, when the rate cap expires, monthly debt payments could skyrocket, thus tanking the reserves and endangering the overall health of the asset.
Buying a new rate cap in the current market could be prohibitively expensive. Selling might not be an option, since valuations have come down in the current market and thus they might be losing money if they were to sell right now.
A refinance might be an option, but not without putting in additional capital, which is where the preferred equity comes into play.
In the refinance scenario, if the valuations have come down, and lenders in many cases are requiring a lower LTV (loan-to-value), this puts syndicators in a bind, leaving them with sometimes a significant funding gap in order to successfully move forward with the refinance on their real estate project.
The Need For Pref Equity
As a result, an increasing number of syndicators in this position are seeking creative financing solutions, including preferred equity. This presents investors with a unique opportunity in the current environment for investors to be part of a real estate transaction for performing assets that need financing support.
Whereas finding new acquisitions that make sense might be more challenging in this current environment, especially given the risks of tightening lender restrictions, investing in existing deals via a preferred equity spot in the capital stack might be a golden opportunity and provide a win-win for all parties involved.
This is especially true since many of these properties are showing strong performance, with high occupancy at market rates, relatively little turnover, and efficient operations.
In most cases, the asset itself is not the issue; it’s the debt piece, particularly in this rising interest rate environment, and pref equity can be the missing link to keep these properties in good health.
How Preferred Equity Investments Are Structured
Just as with any investment, there are a lot of different preferred equity structure options. This can involve a bit of a dance between the lead sponsor on an existing asset and the pref equity partner considering coming in to fill the gap.
Preferred equity can be comprised of a single individual, institutional investors, or a group of investors each putting in a share. Preferred equity investments are often structured as a fund, where investor capital may be invested across multiple assets, to provide further risk mitigation and diversification.
The staples of preferred equity investments are that they’re structured to sit ahead of other investors in the capital stack and they will be paid a fixed rate of return on a consistent ongoing basis.
Other than that, the other terms of the investment – things like ownership in the underlying asset, sharing in the tax benefits, and participating in the upside – are up for negotiation and thus can vary from one preferred equity investment to another.
The most important thing you should know as you consider a pref equity real estate project is that you would sit in a prime position in the capital stack, ahead of other investors, and you should expect to receive a consistent ongoing fixed rate of return.
Why Invest In Preferred Equity Real Estate
Preferred equity may not be as critical a piece at other points in the market cycle, but right now, preferred equity is seeing increasing demand as more and more syndication groups are facing funding shortfalls and needing to seek creative financing.
In this market, cash is king, and preferred equity provides that much needed cash to groups with strong assets but tricky lending issues.
Through preferred equity investments, you would be able to secure a prime spot in the capital stack, ahead of common equity holders. You would also see consistent ongoing returns at a fixed rate, and you’d get a piece of the upside upon sale of the asset.
On top of that, if you’re new to preferred equity, preferred equity investments could give you a great opportunity to diversify your portfolio, not only via asset classes, markets, and operators, but also via different positions in the capital stack.
Fixed Rate Of Return
Plus, for preferred equity holders, returns are often paid out monthly (versus quarterly), and terms are fixed, so you can expect a consistent ongoing stream of passive income.
Best of all, you’d get the opportunity to participate in strong assets and to help “save the day,” so to speak, helping to ensure that these great assets are able to maintain strong performance, make it through the current financial uncertainty, and realize their full potential.
Pros & Cons Of Investing In Preferred Equity
In addition to considering the unique opportunity in the market right now with preferred equity, you should also take time to consider your own investing goals and whether preferred equity is the right instrument to help you achieve those goals.
Below are some pros and cons to consider as you evaluate whether preferred equity is the right investment for you.
Preferred Equity Investment Pros
Priority position – Ensures you get paid out before other investors. This can help to de-risk your investment and protect your capital.
Fixed rate of return – Ensures consistent ongoing monthly payments, which can be much more predictable than projected returns for other investor equity classes and thus contribute more meaningfully to your personal financial situation in the immediate term.
Ability to participate in the upside – Depending on how the investment is structured, preferred equity investors may get a piece of the upside, which would be additional icing on the cake.
Opportunity to fill a true need – In situations where an asset is performing well but may be in a lending bind, preferred equity offers a knight-in-shining-armor level solution to save the day and keep assets on track.
Preferred Equity Investment Cons
Modest growth potential – This one depends on the structure of the preferred equity investment. Some may offer a bit of upside; others may not include upside at all. If you’re looking for a high growth investment vehicle, preferred equity may not meet that criteria.
Limited tax advantages – Typically, preferred equity investors receive much more limited tax benefits as compared with other investors. Most, if not all, the depreciation benefits typically go to common equity holders.
Positioned behind senior debt – If you’re looking for an ultra conservative investment vehicle with limited downside but also limited upside, preferred equity might have too much risk for you, since it sits behind the senior debt and may not be secured by the real estate itself
Investing In Common Vs. Preferred Equity
If you’ve invested with us before, your investment would have been via common equity. As you consider the option of preferred equity and how it might fit into your overall portfolio, we recommend that, rather than thinking of common vs. preferred equity as an “either/or,” try thinking of it as a “both/and.”
Both common and preferred equity investments have their unique advantages and will help you reach certain investing goals. When working in tandem, the two types of equity investments can help you to diversify your portfolio and provide a more stable and consistent ongoing return.
Below are some of the key things you should consider when thinking about investing in common and pref equity.
Overall Risk Level
The benefit of pref equity is that it sits ahead of common equity in the capital stack, thereby mitigating risk, as preferred equity positions you ahead of other investor classes.
However, depending on how a preferred equity investment is structured, pref equity investors may have less control over the property than other investor classes.
The best way to mitigate risk, whether you’re considering preferred equity or common equity investments, is to ensure that you’re investing with sponsors and operators that you know and trust, and who have an established track record of success.
After all, if the operator can successfully navigate through any challenges that arise and still execute on the business plan and achieve stellar returns, all investors will get paid handsomely.
Investor Returns, Cadence, And Upside
In addition to a prime spot in the capital stack, preferred equity can offer strong overall returns, especially when structured with a piece of the upside. Typically, pref equity investors receive a consistent ongoing fixed rate of return, with a smaller piece of the upside than common equity holders.
Common equity investors, on the other hand, may see less consistent cash-on-cash returns, particularly in the early years of the investment, though their preferred return may accrue during that time.
In addition, one major advantage of common equity is that they receive significant tax benefits via depreciation, whereas preferred equity holders may not receive depreciation benefits.
Upon the sale of the asset, common equity investors typically stand to gain the most potential returns, as they own the majority of the upside in the deal.
When investing in both preferred and common equity, you get the best of both worlds – consistent monthly returns, tax benefits, and strong upside upon sale of the asset – thus bolstering your overall portfolio and hedging against shifting market conditions.
Priority In The Capital Stack
As we’ve already discussed, one of the main advantages of preferred equity investing is that pref equity sits ahead of common equity holders in the capital stack.
This means that, when there’s cash flow to be paid out from ongoing real estate operations, preferred equity holders receive priority and would get paid out first. This is what usually gives investors peace of mind when thinking, “Are preferred equity investments safe?”
Here’s a quick example of this in action. If there’s $50k in available cash flow, and the fixed rate return for pref equity investors comes out to $15k, they’ll get paid out in full, even if there’s not sufficient cash flow left over to pay all the common equity shareholders their full preferred return.
The $35k cash flow left over in this example would then go next to Class A investors, who typically sit ahead of the other classes in priority. Let’s say that the total preferred return for Class A investors in this example comes out to $10k. Because there’s enough cash to pay that out in full, Class A would receive their full preferred return.
With the $25k that’s left over, let’s assume that the full preferred return for the other classes of investors (Class B, C, D, etc.) comes out to $40k, which is more than the available cash flow. What would happen in this case is that the $25k would get divided up among those investors, and the additional amount (the $15k that was not able to be paid out) would accrue and be paid out at a later date or upon the sale.
By investing in both common and preferred equity real estate, you can diversify across the capital stack, thus building a strong foundation for your overall portfolio.
If you’re looking to invest in preferred equity to boost and diversify your portfolio, we invite you to join the Goodegg Investor Club, so we can keep you in the loop on upcoming common and preferred equity investment opportunities.
You can also check out our open deals page to learn more about our current or upcoming opportunities.
If you’re not yet ready to invest but are curious about how all of this works, we invite you to dip your toe in the water with us through our free 7-day email course – Passive Real Estate Investing 101 – or to get a copy of our book – Investing For Good.
To learn more about us and our experience, be sure to download a copy of our track record, which shows the projected and actual returns we’ve achieved across all the deals we’ve exited to date.