Investing in commercial real estate requires a significant amount of capital. Individual investors can typically raise enough cash for a residential property deal. But, commercial property deals often require multiple investors – and classes of investors – pooling capital in pursuit of a single project. Understanding these different investor classes allows deal sponsors to better plan for successfully financing a deal. As such, we’ll use this article to answer a question related to one particular investor class: what is commercial real estate preferred equity?
Specifically, we’ll discuss the following topics:
- The Commercial Real Estate Capital Stack
- Preferred Equity Overview and Considerations
- Preferred Equity vs. Common Equity
- Preferred Equity vs. Senior Debt
- Final Thoughts
The Commercial Real Estate 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. Generally speaking, five different categories of financing exist in a commercial real estate capital stack. Not every deal will have each, but investors should have a working understanding of these categories. In the following, we have listed the capital stack categories from least senior / highest risk (common equity) to most senior / lowest risk (senior debt):
Common Equity. At the top of the capital stack, common equity typically includes the funds contributed by a deal’s sponsor, or general partner (GP).
Preferred Equity. These investors are more junior than debt financing but senior to the common equity. As such, they typically receive a minimum required return on their capital.
Mezzanine Financing. Mezzanine financing often acts as a sort of hybrid financing, with elements of both debt and equity. If a deal requires funds to bridge the gap between the debt and equity financing components, the sponsor may secure mezzanine financing to make the deal happen.
Junior Debt. Junior debt represents the second most senior financing category in the capital stack. Frequently, this category includes second mortgages and other construction- or renovation-type loans secured in addition to a first mortgage.
Senior Debt. Senior debt sits at the bottom of the capital stack. As a result, this financing source takes priority over everything above it. That is, with senior debt, the lender holds the first-position lien on the underlying property. In most situations, a deal’s permanent mortgage holds the senior debt position. These loans are amortizing and longer term than most junior debt.
Preferred Equity Overview and Considerations
Overview
Preferred equity falls just below common equity on the capital stack. As owners, these investors 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.
In terms of ownership, preferred equity holders (like common equity holders) don’t hold direct stakes in the commercial real estate itself. Rather, they own a percentage of the entity that owns the real estate. Most deals are organized as limited partnerships (LPs) or limited liability companies (LLCs). In the former, the LP holds title to the real property, and the preferred equity holders have a limited partner stake (as opposed to a general partner stake). In the latter, the LLC holds title, and the preferred equity holders own a percentage of the LLC as investor-members (as opposed to managing-members).
Preferred Equity Considerations
Preferred equity terms are not set in stone. Instead, depending on the unique deal, terms can be modified to meet both the needs of the common equity holders and the investment objectives of the potential preferred equity holders. As a result, investors should understand the differences between 1) soft and hard, and 2) participating and non-participating preferred equity.
Soft vs. Hard Preferred Equity. Soft preferred equity holders only collect distributions when the deal generates sufficient cash flow. That is, preferred equity receives cash before common equity, but it isn’t guaranteed a regular payment. 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 vs. Non-Participating Preferred Equity. “Participation” relates to what happens to the preferred equity holders with returns above their minimum required return. When non-participating, the preferred equity holders don’t receive any upside benefit. That is, if total returns exceed their minimum required return, preferred equity just receives cash flows up to that minimum. 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.
Preferred Equity Example
Deal sponsors typically offer preferred equity terms to cover the cash gap between 1) the common equity investment, and 2) the debt financing secured. For instance, say a deal sponsor wants to purchase an apartment building for $20 million. The sponsor secures senior debt (i.e. a permanent mortgage) for 70% loan-to-value, or $14 million. This leaves a cash gap of $6 million. If the sponsor plans to contribute $2 million of his own capital as common equity, preferred equity could cover the remaining $4 million cash gap.
But, what happens if this deal goes south? As discussed in the capital stack section above, preferred equity is senior to common equity. Let’s say that, after a couple years, the property’s performance collapses, its value sinks to $18 million, and the bank (i.e. the senior debt holder) needs to foreclose. Ignoring transaction costs and loan amortization, the bank receives $18 million in the foreclosure sale. As the senior debt holder, the first $14 million of that sale pays off the outstanding loan balance. The remaining $4 million goes to the preferred equity holders, as they have a more senior claim than common equity. Unfortunately, as the most junior member of the capital stack, this leaves the common equity holders with a total loss on their $2 million investment.
Preferred Equity vs. Common Equity
Deal Involvement
Preferred equity holders generally don’t have any involvement in a deal’s day-to-day planning and operations. Rather, their role is limited to capital contribution. Common equity holders, on the other hand, play an active role in a deal. While third-party property management firms are often hired, common equity holders play a key role in deal supervision, decision making, and financial reporting.
Cash Flow Priorities
Due to their relative seniority, preferred equity holders have a higher claim on a deal’s cash flow and sales proceeds than common equity. Once all debt claims and operating expenses have been settled, preferred equity collects its required returns before common equity does.
Potential Returns
Depending on the deal and broader economic conditions, preferred equity required returns generally fall between 8% and 15%. In a successfully planned and executed deal, the common equity holders will likely earn returns several percentage points higher (or more) than the returns on preferred equity.
Preferred Equity vs. Senior Debt
Cash Flow Priorities
Senior debt must be serviced before any preferred equity cash distributions. During stabilized operations, this means that the monthly debt service, operating expenses, and necessary capital expenditures must be paid prior to any cash distributions to preferred equity holders. At sale or refinance, the entire senior loan balance plus any accrued interest must be paid, and then the preferred equity holders receive cash distributions.
Potential Returns
Like preferred equity, senior debt returns largely depend on broader economic conditions. Over the past decade, interest rates on long-term commercial real estate mortgages have ranged from 2% to 7%. These rates closely follow the 10-year Treasury, with mortgages 2% to 5% higher than the bond, depending on the deal and borrower’s creditworthiness.
Final Thoughts
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. From a deal sponsor’s perspective, raising funds via preferred equity offers two key advantages. First, preferred equity holders normally receive a proportionally lower return once they hit their minimum required return. Second, preferred equity holders generally don’t have any say in a deal’s planning and execution. Instead, the preferred equity holders provide capital, while the sponsors focus on their area of expertise – the deal’s planning and execution.
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