Why Preferred Equity is a Popular Option for Institutional Investors
Investors in commercial real estate balance two competing items: yield and risk. That is, investors seek to find a balance between the returns a deal will generate and the various risks associated with that deal. Depending on the particular investor’s unique situation, strategy, and tolerance, the balance between yield and risk will shift one way or the other. Recently, preferred equity has become a popular option for institutional investors, and we’ll explain the reasoning behind this phenomenon in this article.
Specifically, we’ll cover the following topics:
- What is Preferred Equity?
- Why Institutional Investors See Preferred Equity as a Popular Option
- Final Thoughts
What is Preferred Equity?
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. More often than not, institutional investors join a deal as hard preferred equity holders, as this structure provides more predictable returns for a fund.
Why Institutional Investors See Preferred Equity as a Popular Option
What is an “Institutional Investor”?
Institutional investor serves as an umbrella term. The term includes companies or other organizations that invest on behalf of other people. Accordingly, mutual funds, pension funds, and insurance companies fall into the “institutional” category.
Institutional investors typically have 1) far more capital than individual investors, and 2) a level of responsibility to the individual investor comprising their raised capital – not just to themselves. These two traits lead into the below three advantages to preferred equity that make it such a popular option for institutional investors.
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 institutional investors worry about future negative macroeconomic trends, they can “lock in” returns via preferred equity deals. When an institutional investor takes a hard preferred equity stake in a deal, it establishes both a regular income stream and predictable total returns on behalf of its fund.
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 institutional 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 institutional 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 institutional 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.
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. Participation deals with what happens to the preferred equity holders with returns above their minimum required return. 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 institutional investors looking for a combination of downside protection and potential upside.
Preferred equity offers predictable returns while minimizing downside risk. For institutional investors navigating periods of economic turmoil on behalf of their funds and individual investors, these traits make preferred equity appealing. In sacrificing the upside of common equity, preferred equity offers consistent income with the comfort of greater downside protection than common equity.
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