A saying exists in commercial real estate: “financing is king.” If you lack an effective financing plan, you’ll fail to execute a deal, regardless of its quality. This reality leads savvy investors and deal sponsors to research creative ways to raise capital. In addition to the broad categories of debt and equity, other sub-categories of financing exist. In this article, we’ll review one of these: preferred equity in real estate.
Specifically, we’ll cover the following topics:
- Preferred Equity Overview
- Benefits of Preferred Equity in Real Estate
- Additional Preferred Equity Considerations
- Final Thoughts
Preferred Equity Overview
What is Equity?
Broadly speaking, two types of real estate financing exist – debt and equity. Debt entails a relationship between a lender and borrower. The lender provides financing but doesn’t receive an actual ownership interest in the property. Instead, the lender typically secures its position by placing a lien on the underlying real estate. If the borrower defaults (i.e. fails to repay the loan), the borrower can foreclose on that underlying collateral to recoup its funds.
Equity, on the other hand, involves direct ownership in a real estate deal. When deal sponsors raise equity funds, they sell a stake in their entity. The investor / equity holder then owns a percentage of the deal. Typically, these ownership stakes take the form of either limited partner (LP) or limited liability company (LLC) positions.
Preferred Equity, Common Equity, and the “Capital Stack”
Commercial real estate investors describe a deal’s different financing sources as its “capital stack.” Senior debt (i.e. a permanent mortgage) sits at the bottom of the stack, offering the lowest risk and returns. Common equity (i.e. ownership stake in a deal) sits at the top, providing the highest risk but also the highest potential returns.
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 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.
Benefits of Preferred Equity in Real Estate
Preferred Equity – an Investor’s Perspective
From an investor’s perspective, preferred equity offers two major advantages. First, it commands higher returns than any type of debt. Second, unlike common equity holders, preferred equity holders generally have a minimum required return. For example, with cash after debt service and operating expenses, preferred equity holders could receive 8% (or whatever minimum required return defined in the deal) on their investment before any distributions to common equity holders.
Preferred Equity – a Deal Sponsor’s Perspective
Raising funds via preferred equity offers two key advantages to a deal’s sponsor (i.e. the individual planning and executing the deal). First, preferred equity holders normally receive a proportionally lower return once they hit their minimum required return. For instance, a deal may call for an 8% minimum required return, then allow for the sponsor to “catch up” to that 8%. Any returns above that catch-up amount would be allocated at a higher rate to the sponsor than the preferred equity holders (e.g. sponsor receives an additional 20% of all returns above the catch-up). These higher returns for the sponsor are often referred to as promoted interest, or “promotes.”
Second, preferred equity holders generally don’t have any say in a deal’s planning and execution. For a sponsor, this prevents the headache of “too many cooks in the kitchen,” that is, input from every investor in a deal. Instead, the preferred equity holders provide capital, while the sponsors focus on their area of expertise – the deal’s planning and execution.
Additional Preferred Equity Considerations
Preferred Equity as Leverage
Simply put, leverage means using other people’s money to finance your real estate deal. Debt financing provides the primary source of a deal’s leverage. For instance, a sponsor contributes 25% of a deal’s capital requirement as equity and secures a mortgage loan for the remaining 75%.
But, in many situations, sponsors may not want to tie up all of their available cash in a deal. Realistically, though, lenders will only provide funds up to a certain threshold – typically 60% to 80% loan-to-value (LTV), depending on the unique situation. Say that, in a given $20 million deal, the sponsor secures a 70% LTV mortgage, providing $14 million in financing. If the sponsor only wants to contribute 10%, or $2 million, that leaves a $4 million cash gap.
By raising the remaining $4 million with preferred equity, the sponsor increases his leverage – and potential returns – on the deal while still meeting the lender’s LTV constraint. Put differently, the sponsor has successfully leveraged debt and preferred equity financing to control a $20 million deal with only $2 million in contributed capital.
Reasons to Avoid Preferred Equity
The Sponsor Doesn’t Need the Preferred Equity Financing. If the sponsor executes a solid deal, he should receive higher total returns than the preferred equity holder through the promoted interest step. But, a poorly performing deal may mean that the total cash flow doesn’t reach the promotes. In this situation, the preferred equity holders receive all or part of their required return, while the sponsor only has his capital returned. Conversely, if a deal only included common equity, all those owners would equally share in the deal’s returns – for better or worse. As such, if you can execute a deal without selling preferred equity stakes, it often makes sense to only use common equity.
Lenders Impose Due Diligence Requirements on Preferred Equity. Due to its debt-like characteristics, some lenders may view preferred equity – particularly hard preferred equity – as debt financing. This treatment will likely result in stricter underwriting standards from the lender. In practical terms, this makes closing on a permanent mortgage more difficult, as the lender will apply due diligence and underwriting standards to the preferred equity as if it were subordinate debt (as opposed to common equity).
Final Thoughts
From both a sponsor’s and investor’s perspective, preferred equity plays an important role in the commercial real estate capital stack. For sponsors, it allows increased leverage while minimizing upside payouts. For investors, it provides a greater level of protection than common equity while offering higher returns than senior debt. But, as with all financing sources, the decision to pursue preferred equity will largely depend on the unique nature of a given deal.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.