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. In short, preferred equity is subordinate to debt, but senior to all common (or JV) equity.
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 bare some differences beyond that.
Preferred equity provides sponsors and developers a higher amount 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.
Why Invest in Preferred Equity Real Estate
Preferred equity offers a hybrid risk/return profile between senior debt (which typically carries the added security of a first lien on the property, as well as first payment priority) and common equity, which carries unlimited upside but is subordinate to all debt and preferred equity.
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”.
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%*.
Preferred equity real estate investments are also an attractive vehicle for yield during periods in the market cycle when a correction feels likely, if not inevitable and imminent (market conditions as of this writing could be described as such).
To summarize, these are the main reasons preferred equity real estate investments are attractive:
- 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)
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, especially at this point in the market cycle.
However, this should be considered another opportunity for diversification: diversifying across senior debt, preferred equity, and common equity – and, by extension, diversifying across hold periods – can help mitigate liquidity risk.
The precise mix of debt, pref. equity and equity investments should be driven by your overall goals and strategy; your tolerance for risk and need for liquidity.
Preferred equity real estate as part of diversified hold period strategy.
A hypothetical portfolio of debt, common equity, and preferred equity real estate investments.
With reinvestment of repaid debt investments, the investor is projected to enjoy regular cash flow that increases throughout the 7 year period, with the initial capital outlay recovered within 4 years and the potential for substantial upside through years 4-7.
The basic premise is similar to the “100 minus your age” theorem of stock vs. bonds allocation (that may be more superstition than theory at this point) – 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.