Commercial real estate deals require far more capital than most individual investors can raise. To bridge the gap between a deal’s cash needs and common equity contribution, many investors turn to preferred equity. This financing source provides both flexibility and access to a significant amount of capital, but many investors lack a thorough understanding of how it works. As such, we’ll use this article to provide a complete guide to real estate preferred equity.
Specifically, we’ll cover the following topics:
- The Real Estate Capital Stack and Preferred Equity
- Participating vs. Non-Participating Preferred Equity
- Soft vs. Hard Preferred Equity
- Development vs. Acquisition Preferred Equity
- Advantages to Preferred Equity in Real Estate
- Final Thoughts
The Real Estate Capital Stack and Preferred Equity
The Commercial Real Estate Capital Stack
Before discussing preferred equity, we need to cover the capital stack, in general. In commercial real estate, investors often need multiple funding sources to make a deal happen. A deal’s capital stack refers to the specific composition of these different sources.
It helps to visualize a capital stack as a literal stack. On the top of the stack, you have the common equity. These are the funds that command the highest returns, but they also include the most risk. If a deal goes south, the common equity holders are the last to have their investment returned.
At the bottom of the capital stack, you have the senior debt. This is the first position mortgage loan. That is, the loan is actually secured by the underlying real estate. Accordingly, if the deal falls apart, the senior debt holder receives its cash back before anyone. As such, this capital has the lowest risk, but it also offers the lowest returns.
A variety of financing options exist between common equity and senior debt (e.g. junior debt, mezzanine loans, and preferred equity). From a visualization perspective, the “higher” you go on the capital stack, the greater your potential returns and risk.
Preferred Equity Overview
Preferred equity falls just below common equity on the capital stack. As owners, these investors also face more risk than debt holders. But, preferred equity typically comes with a minimum required return that must be paid before common equity returns. This required return reduces risk – but also potentially limits the potential upside preferred equity holders can receive. That is, due to the risk common equity holders take, they claim a disproportionate share of all returns above the minimum required returns defined in the preferred equity agreement.
Preferred Equity Hold Periods and Terms
While individual agreements vary, preferred equity holders typically invest in real estate deals for three- to five-year periods. However, due to the flexibility this financing source offers, individual investors may opt for shorter or longer hold periods depending on their objectives and the unique nature of the deal.
In the following sections, we’ll provide further evidence of the flexibility preferred equity offers by outlining various forms it can take and ways deal terms can be customized. Depending on its particular form, preferred equity often looks like either joint venture equity or mezzanine debt.
Participating vs. Non-Participating Preferred Equity
One way preferred equity terms can be customized is by participation. As stated above, preferred equity holders typically receive a minimum required return. For example, a deal’s cash waterfall may require that the preferred equity holders receive a 10% internal rate of return (IRR) before the common equity holders receive any return on investment. Participation deals with what happens to the preferred equity holders with returns above their minimum required return.
Non-participating preferred equity. When non-participating, the preferred equity holders don’t receive any upside benefit. That is, if total returns exceed their minimum required return, they don’t see any of that upside; preferred equity just receives cash flows up to that minimum. This approach overlaps with mezzanine debt financing.
Participating preferred equity. When participating, preferred equity holders have the potential for some upside benefit, similar to joint venture equity. If the deal generates returns above the preferred minimum, these equity holders collect a percentage of that upside. The individual deal terms will dictate what percentage of the upside these equity holders will receive.
Soft vs. Hard Preferred Equity
In addition to the participating vs non-participating categorization, preferred equity can also be customized with a soft or hard status. Real estate deals – like all investments – include risk. In particular, investors face the risk that a deal may not generate enough cash flow to meet its initial projections. Soft and hard preferred equity provide different treatments for these poorly performing deals.
Soft Preferred Equity: These equity holders only collect distributions when the deal generates sufficient cash flow. After the sponsor pays all debt obligations and operating expenses, the preferred equity holders receive the remaining distributable cash. However, no absolute payment obligation exists. That is, preferred equity receives cash before common equity, but it isn’t guaranteed a regular payment. In this respect, soft preferred equity has similarities with joint venture equity financing.
Hard Preferred Equity: Conversely, hard preferred equity mandates regular distributions. Somewhat similar to mezzanine debt financing, these equity holders demand regular payments, regardless of a deal’s performance. If the deal sponsor fails to make one of these payments, the preferred equity holders may have the right to seize control of the deal’s management or ownership, depending on the particular preferred equity agreement.
Development vs. Acquisition Preferred Equity
Real Estate Development and Preferred Equity
Real estate development is the business process of improving either raw land or existing structures. Developers use these real property improvements to increase the value of that property. That is, these developers create new property improvements from a previously unproductive (or less productive) piece of land. Depending on the deal, developers may then choose to either A) sell that new building, or B) lease it to tenants.
For example, let’s start with a parcel of unimproved land. A developer could look at that land, design a plan for improving it into a series of townhomes, figure out how to finance the construction of those homes, receive local permitting approval, then supervise the construction of those townhomes. Following the construction process, this developer could continue to lease the homes for rental income, sell them to another real estate investor, or sell them to individual homeowners.
While ground-up development offers the potential for large returns (historically the largest of all real estate strategies), those potential returns come with a tremendous amount of risk. During the due diligence, feasibility, and permitting phases, developers must pour tens of thousands of dollars (or more) into soft costs and land acquisition before they even know if the deal will ultimately be approved. Then, during construction, developers further run the risks of cost overruns, market changes, and interest-rate fluctuations on variable-rate construction loans.
Due to all of the above risk factors, many preferred equity investors won’t join a ground-up development deal until it has been fully stabilized, that is, construction completed and leased. At that point in time, preferred equity capital enters the deal, the permanent financing is closed, and the construction loan and any bridge financing are curtailed. This allows preferred equity investors to generate solid returns on a development deal while avoiding much of the up-front risk.
Depending on a developer’s track record, some investors may consider preferred equity stakes during the construction process, but they will likely demand a higher required return to offset the associated risk.
Stabilized Acquisitions and Preferred Equity
Unlike ground-up development, the stabilized acquisition strategy entails investing in currently operating properties. For example, an investment group may raise funds to purchase a leased-up apartment building, operate it for several years (often with a value-add approach), then sell the property to generate returns.
Raising preferred equity for these sorts of deals faces far fewer hurdles than ground-up developments. Simply put, fewer unknowns exist, so a potential investor can join a deal with less risk. With a stabilized property, the underwriting can include confirmed acquisition costs, operating expense history, and the current rent roll, whereas developers must make many assumptions here.
With this approach, a deal principal (also known as a sponsor or syndicator), finds, underwrites, and executes an acquisition investment. As part of that underwriting process, the principal identifies the cash gap, that is, the difference between the cash required and the cash he plans on personally contributing.
With this cash gap and the deal’s projected returns identified, the principal pitches the deal to potential preferred equity investors. These investors receive a minimum required return – paid out prior to the principal receiving a return on his equity investment. If the deal’s performance exceeds this minimum return, the principal receives a disproportionate amount of that upside through his catch-up return and promoted interest distributions. This set-up A) protects the preferred equity investors, and B) incentivizes the principal.
Advantages to Preferred Equity in Real Estate
Preferred Equity Pro #1: Minimum Required Returns
As interest rates have soared over the past year, yields across many asset classes have compressed. In commercial real estate, particularly, increased rates drive higher debt service, which lowers total returns. In this environment, preferred equity offers a predictable, fixed rate of return for the duration of a deal. As investors worry about future negative macroeconomic trends, they can “lock in” returns via preferred equity deals. When an investor takes a hard preferred equity stake in a deal, it establishes both a regular income stream and predictable total returns.
Preferred Equity Pro #2: Downside Protection and Risk Mitigation
A significant number of economists predict a recession in the near future. As a result, many investors are focusing more on mitigating risk with downside protection than chasing massive yields.
A real estate deal’s common equity holders have the potential for the highest returns in a deal. But, in case of poor performance (or, in a worst case scenario, default), preferred equity holders are paid out prior to common equity. This structure allows investors to both invest at a defined rate of return while still maintaining a level of downside protection – a solid position during periods of economic uncertainty.
Preferred Equity Pro #3: Upside Potential (Possibly)
Yes, current macroeconomic conditions have led many investors to seek consistent income over outsized returns. But, that doesn’t mean these same investors all want to completely forsake upside potential in a deal.
When participating, preferred equity holders have the potential for some upside benefit. If the deal generates returns above the preferred minimum, these equity holders collect a percentage of that upside. The individual deal terms will dictate what percentage of the upside these equity holders will receive, but this structure may prove attractive to investors looking for a combination of downside protection and potential upside.
Preferred equity offers real estate investors an extremely flexible financing option. Depending on the deal terms, preferred equity may look more like joint venture equity or mezzanine debt. But, regardless of how you structure a deal, real estate developers and investors should consider the potential benefits of including preferred equity in their capital stack.
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