Preferred Equity Real Estate – Some Background Context
Preferred equity is part of the real estate capital stack — in other words, a type of financing a sponsor or developer will employ as part of the aggregate capital raise for a given real estate project. Among these, preferred equity is subordinate to debt, but senior to all common (or JV) equity. Like mezzanine debt, preferred equity is used by real estate sponsors and operators as a form of “bridge financing.” Capital raised in a preferred equity position serves to bridge the gap between a senior loan and the common equity portion of the capital stack.
Key Takeaways
- Preferred equity is a hybrid product, offering a share of upside and payment priority over common equity positions.
- It can be attractive at all stages of the market cycle, though particularly at or near the top of the market.
- Diversifying across the capital stack and staggering hold periods can potentially help long-term growth and mitigate liquidity risk.
Investing in preferred equity is a new option for most individual investors. EquityMultiple brings individual investors a new level of access to distinct preferred equity investments.
Preferred equity is similar to mezzanine debt in function, but slightly different in form. Mezzanine debt functions as bridge financing, but rather than being secured by the underlying property, the sponsor puts up his common equity position as collateral. Preferred equity, conversely, is typically entitled to force sale of property in the event of non-payment. Preferred equity also typically includes an “equity kicker”—an additional entitlement to profits in the event that the project performs well—whereas mezzanine debt does not. In other words, both mezzanine debt and preferred equity provide gap funding, seniority to common equity, and legal remedies in the event of non-payment, but bear some differences beyond that.
Why Invest in Preferred Equity Real Estate
Preferred equity offers a hybrid risk/return profile. Like senior debt, preferred equity investments carry payment priority over common equity investors and some recourse provisions in the case of borrower default. Like common equity, preferred equity investments typically entitle passive investors to some share of the upside upon exit of the investment—though this upside is capped in preferred equity investments.
Preferred equity investments typically offer a robust flat annual rate of return, as well as the aforementioned “equity kicker”—the opportunity to share in the upside of the project. In many cases, though not all, the exit is projected at refinance or partial sale, making the term shorter than the average common equity investment.
Thus, preferred equity real estate investments are attractive for those investors that like the predictable annual returns and regular distributions of a debt investment, and are willing to sacrifice some downside protection in exchange for an additional layer of upside potential—the “equity kicker.” EquityMultiple’s preferred equity real estate investments typically offer current annual preferred returns between 7-12%*, and total preferred returns (including the equity kicker or accrued return) between 10 and 15%*.
What type of real estate can you access with EquityMultiple, including preferred equity real estate opportunities?
Preferred equity real estate investments are also an attractive vehicle for yield during periods in the market cycle when a correction feels likely (many economists have described market conditions as such). Most of EquityMultiple’s recent preferred equity investments have projected to total preferred returns exceeding the typical annual performance of the S&P 500 in recent years, while still offering decent downside protection by virtue of payment priority and rights in the event of a sponsor default.
To summarize, investors find preferred equity real estate investments attractive for the following reasons:
- More upside than senior debt-based real estate investments
- Payment priority over common equity holders
- Downside protection (particularly attractive at or beyond a likely market peak)
Characteristic | Preferred Equity | Common Equity |
---|---|---|
Repayment Priority | Higher priority than common equity, paid before common equity | Lower priority than preferred equity, paid after preferred equity |
Upside Potential | Limited upside, typically capped return. Some structures allow participation in upside profits but less than common equity | Unlimited upside potential, participate fully in profits |
Return Structure | Typically fixed rate, can be current pay (regular distributions) and/or accrued return paid at exit | Variable dividends/distributions based on performance |
Preferred Equity Real Estate Investing vs. Debt and Common Equity
Should you allocate your entire real estate portfolio to preferred equity real estate? Hopefully we’ve made a compelling case for this type of investment, and indeed you may want to devote a substantial portion of your real estate portfolio to preferred equity.
Preferred equity presents another opportunity for portfolio diversification. Investors can mitigate liquidity risk by diversifying across senior debt, preferred equity, and common equity, and by diversifying across hold periods. We encourage investors to consider their overall goals and strategy—as well as risk tolerance—to inform the precise mix of debt, preferred equity and equity investments in their portfolio.
EquityMultiple allows for investing across the capital stack, enabling investors to achieve this diversification of hold period and risk/return profile.
The basic premise is similar to the “100 minus your age” theorem of stock vs. bonds allocation (although that cliché may be more superstition than theory). While you should reduce the portion of high-upside, high-potential-return investments in your portfolio the closer you get to retirement (and the more risk averse you are to begin with), devoting some of your portfolio to longer-term appreciation and upside will aid the growth potential of the portfolio overall.
By staggering the projected term of your investments, you can put yourself in position to reclaim capital for reinvestment and/or to have more liquid assets on hand.
Position | EquityMultiple Pillar | Duration | Income Potential | Upside Potential | Downside Protection |
---|---|---|---|---|---|
Alpine Note | Keep | Shortest | Near-term (<1 year) yield | None | First-loss protection |
CRE Debt | Earn | 9-24 months | Generally 8-14% fixed-income | Generally none | Payment priority, recourse |
Preferred Equity | Earn | 12-36 months | Generally 10-15% fixed- income | Often a “kicker” at exit, but limited. | Intermediate payment priority and recourse |
JV Equity | Grow | 3 years+ | Varies, but not contractually obligated | Most versus other positions | None |
Preferred Equity Investments on EquityMultiple
Preferred equity provides sponsors and developers a higher degree of leverage at a lower cost than common equity (assuming that the project performs well and to expectations). For preferred equity real estate investors, it provides the opportunity to capture a fixed rate return with priority of payment and some upside.
Postscript: A Note on Today’s Lending Environment
Update — 2024
With a potential “higher for longer” interest rate regime, the demand for preferred equity financing and other bridge financing may rebound quickly as underwriting standards of traditional lenders tighten. Lenders may only lend to a lower LTC or LTV versus a year ago for an equivalent asset and borrower. This creates opportunities for issuers of preferred equity and other types of bridge financing.
At EquityMultiple, we are continually keeping our eyes out for interesting preferred equity opportunities. As of this writing, we believe there may be a gap in the market. Specifically, in the current interest rate environment, traditional lenders may not be willing or able to offer loans at the same low rates as they would have previously. Real estate developers and operators will then likely need to find alternative sources of financing–including through market solutions like EquityMultiple. While our Ascent Income Fund is predicated on debt, we will also look to source compelling preferred equity real estate investment opportunities in the months ahead.
Note also that a potential inflationary environment creates another potential reason to consider preferred equity real estate investing: the accrued interest, or “kicker,” may provide an additional boost to real returns during the tail end of the investment’s term.
FAQs — Preferred Equity CRE Investing
Still have questions about preferred equity and CRE investing? We have answers.
Are preferred equity investments a good idea?
Preferred equity investments in commercial real estate can offer an attractive risk-adjusted return thesis. If you are focused on income but seek more upside than debt investments offer, preferred equity may be a good option.
Are preferred equity investments safer than equity investments?
As the name suggests, preferred equity positions hold payment priority over common equity. All else being equal, this does provide safety versus a common equity investment. However, various attributes of the underlying property and the sponsor or operator are very important in terms of the safety of the investment. Quality sponsorship, responsible leverage, market fundamentals, and asset quality are all critical to look at, regardless of whether you’re evaluating a preferred equity or common equity investment.
Are there any drawbacks to preferred equity investments?
While preferred equity mitigates some risk by having a higher repayment priority, there is still a possibility of losing the entire investment if the asset performs poorly enough, unlike debt investments. Preferred equity may be better suited for investments with diversified income streams, like multifamily properties with many tenants. It may be riskier for single-tenant investments where losing that one tenant could severely impact the asset’s value and potentially wipe out all equity holders, regardless of their payment priority. In exchange for this reduced risk compared to common equity, preferred equity investors give up a portion of the upside return potential if the investment is wildly successful.
Where can I find preferred equity investments?
Preferred equity is not available everywhere. While preferred equity positions can benefit all parties, debt and common equity are more common to find on real estate investing platforms. EquityMultiple offers debt, preferred equity, and common equity investments.