Financing plays a central – if not the central – role in making a commercial real estate deal happen. However, far more financing options exist in commercial than residential real estate deals. This multitude of options often overwhelms new investors. When underwriting a deal, investors may not know what financing sources make the most sense. As such, we’ll use this article to explore two common commercial real estate options: preferred vs joint venture equity.
Specifically, we’ll discuss the following topics:
- Preferred Equity – Overview, Pros, and Cons
- Joint Venture Equity – Overview, Pros, and Cons
- Preferred vs Joint Venture Equity
- Final Thoughts
Preferred Equity – Overview, Pros, and Cons
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.
Raising funds via preferred equity offers two key advantages to a deal’s sponsor / general partner (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 you focus on your area of expertise – the deal’s planning and execution.
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.
Joint Venture Equity – Overview, Pros, and Cons
Many business opportunities require more resources than a single firm can provide. Joint ventures provide a solution. With a joint venture, two or more businesses pool their resources to pursue a single project, typically with all parties sharing a deal’s common equity. Especially with particularly large real estate deals, single firms lack A) the capital, or B) the expertise to single-handedly execute a deal. Instead, two or more firms form a joint venture to pool capital and skills in pursuit of a single deal.
NOTE: The IRS does not recognize joint ventures as a formal tax designation. Rather, businesses forming joint ventures typically establish a separate legal entity (e.g. corporation or LLC). This separate entity would then receive tax treatment in accordance with IRS guidelines. Normally, joint ventures are taxed as either partnerships or corporations.
Commercial real estate deals require a ton of capital, generally far more than a residential transaction. Joint ventures provide a means to share these costs among two or more firms – a central advantage to this model. Additionally, when you partner with another firm, you have the advantage of their expertise. For instance, a real estate developer may partner with a private equity firm. The developer contributes land and expertise, and the private equity firm raises the required capital and provides legal services. In this fashion, each party depends on the other to make the deal happen.
Additionally, all parties generally receive common equity in a joint venture model (though this isn’t a requirement). As a result, a deal’s risk is shared among all parties to the venture, that is, shared risk of poor performance.
When you form a joint venture, you inevitably sacrifice some level of control. By their nature, joint ventures entail shared responsibilities in a deal (as opposed to soliciting an investor/partner via preferred equity). And, some real estate investors prefer to control all of a deal’s planning and execution, an approach that makes joint ventures less attractive.
Related to control, the common equity discussed above has an associated disadvantage. Yes, by sharing the common equity with joint venture partners, you share risk. Conversely, you also have to share in a deal’s upside. That is, if the deal’s returns exceed expectations, all parties to the joint venture will share in the promoted interest (unless an operating agreement specifically says otherwise).
Preferred vs Joint Venture Equity
Having outlined the above, the question becomes: if I’m raising funds for a deal, what makes more sense, preferred or joint venture equity? No “right” answer exists. Rather, answering this question depends on 1) the deal itself, and 2) your priorities.
If the deal proves too large or complicated to handle on your own, joint venture equity may offer a solution. By bringing on other partners, you can leverage their capital and expertise to tackle a project that you couldn’t handle alone.
On the other hand, if you want to control all aspects of a deal but lack the necessary capital, preferred equity offers a solution. While this funding comes with minimum required returns, these investors also generally don’t have any decision-making power (or expectations). You plan and execute the deal, and the preferred equity partners collect a return on investment.
When financing a deal, preferred and joint venture equity have their own pros and cons. And, it’s important to note that they’re not mutually exclusive. That is, if it makes sense in a particular deal, you can certainly use both preferred and joint venture equity.
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 commercial real estate investment opportunities.