Commercial real estate deals typically include far more financing sources than residential. Whereas the latter relies on a long-term mortgage (debt) and owner down payment (equity), commercial deals regularly combine a variety of debt and equity sources. Commercial real estate investors should have a solid understanding of each one of these options, as they’ll likely arise in a future deal. As such, we’ll use this article to discuss one particular financing option, providing an overview of participating preferred equity.
Specifically, we’ll cover the following topics:
- The Capital Stack in Commercial Real Estate
- What is Preferred Equity?
- Participating Preferred Equity and “Backend Kickers”
- Final Thoughts
The Capital Stack in Commercial Real Estate
Before discussing participating 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, preferred equity, and mezzanine loans). From a visualization perspective, the “higher” you go on the capital stack, the greater your potential returns and risk. In addition to several other options, participating preferred equity can potentially cover the gap between common equity capital and the senior mortgage to make a deal happen.
What is 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.
Soft vs Hard Preferred Equity
Two sub-categories of preferred equity exist – soft and hard. 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.
Hard Preferred Equity: Conversely, hard preferred equity mandates regular distributions. Somewhat similar to 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.
Participating Preferred Equity and “Backend Kickers”
Participating Preferred Equity
In addition to the soft and hard sub-categories, preferred equity is further categorized 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 an 8% 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.
Participating preferred equity. 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.
A Backend Equity Kicker Example
In commercial real estate, most of a deal’s returns usually come when the property is sold, that is, at the back end of a deal. Accordingly, a “backend equity kicker” refers to an incentive provided to certain preferred equity holders related to potential returns upon property sale.
Continuing the above example, let’s assume a deal sponsor (i.e. the common equity holder) raises preferred equity capital by promising an 8% minimum required return. The potential investors are bullish on the deal, seeing significant potential upside. As a result, they demand a participating preferred equity agreement via a 10% backend kicker. Here’s how a hypothetical cash waterfall for that deal could work:
Step 1, Return of Capital: The first $5 million of the deal’s distributable cash returns the initial capital contributions for all equity holders – common and preferred.
Step 2, Preferred Equity Minimum Required Return: Once an additional $1 million has been generated, the preferred equity holders meet their 8% minimum return.
Step 3, Sponsor Catch-up: The next $2 million generated ensures that the deal sponsor also achieves some required return.
Step 4, Preferred Equity Backend Kicker: Assume that, after the deal’s total cash flows (operating and sale), have covered the first three steps, $1 million in distributable cash remains. This is where the backend equity kicker goes into effect. Due to the participating nature of the preferred equity, these investors will receive $100,000, or 10%, of this cash, with the common equity holders receiving the rest. In other words, the backend kicker allows the preferred equity holders to collect a share of the deal’s upside beyond their minimum required return.
Final Thoughts
For deal sponsors, including participating preferred equity in your capital stack can be an effective way to finance a deal. For investors, participating preferred equity offers a solid option to generate returns with a combination of downside protection and upside potential.
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