Real estate developers or owners (I’ll refer to them as project sponsors) want to increase their leverage. Preferred equity helps them do that by financing a project with capital that is junior (lower priority) to the mortgage debt but senior (higher priority) to the equity the project sponsor already has in the project.
Normally, real estate lenders will not loan in excess of 80% of a property’s value. This is because the lender wants to give themselves some cushion of protection if things go wrong. These first-position loans are typically more in the 60%–70% range.
In the real estate investing realm, mortgages are often referred to as senior debt. This is a financing position that: (1) is acquired privately from a mortgage lender, (2) is not bought, sold or traded on the stock exchanges and (3) has no central rating system.
So while senior debt gets the real estate ventures funded most of the way, the project sponsor will sometimes need more money to finance more of the deal. That’s where preferred equity comes into play.
What Is Preferred Equity?
Preferred equity is more expensive than senior debt. It’s also riskier for investors. It’s more likely to be adversely affected if the property’s value decreases. So the interest rates paid to investors are higher to compensate for the added risk.
Often, project sponsors seek even more financing by offering common equity positions. This is the least secure (riskiest) but most lucrative position for investors. Lenders and preferred equity financers get favorable interest rates, but if the property has increased in value, it’s the common equity position investors who get to reap those (often greater) rewards.
These rewards often include:
· Share in gains from property appreciation;
· Rental income distributions; and/or
· Benefits from potential tax deductions such as depreciation.
Preferred vs. Common Equity
Preferred equity investors favor a fixed return and priority as to both the return of their investment and the return on their investment. This is particularly true of institutional investors.
Typically, preferred equity has contractual rights contained in the project’s operating agreement. Preferred equity also avoids the need of an inter-creditor agreement with the senior lender and enjoys a better position in any bankruptcy scenario.
Like debt, preferred equity most often involves a fixed term. This is usually two to five years. At the end of the term or in the event of certain triggering events related to the nonperformance of the sponsor, the sponsor is typically required to redeem the preferred equity interest for a redemption price equal to the unreturned capital plus any accrued but undistributed interest earnings.
Common equity, on the other hand, is more than just a loan. It is buying into the project. An investor receives a percentage interest in the project. That way, she receives a part of any increase in the value of the completed project. Or she might receive a portion of rental income. Or both. This is pretty much like buying stock from your broker. You own a portion of the company. But if the project loses money, the investor may also lose her money.
The most common differences are detailed as follows:
Preferred Equity (also called “mezzanine” on some platforms)
Common Equity (also called just “equity” on some platforms)
Preferred Equity ~ Subordinate to mortgage debt but superior to common equity
Common Equity ~ Subordinate to all other debt
Preferred Equity ~ Redemption right at specified date
Common Equity ~ Paid in full on specified maturity date
Preferred Equity ~ Fixed preferred return rate
Common Equity ~ Fixed or floating interest rate with a portion of equity specified in the Owner’s Agreement
Preferred Equity ~ Most often, but not always, a direct equity interest in property
Common Equity ~ Indirectly secured by property through the project sponsor’s pledge
Preferred Equity ~ Approval needed from preferred equity holder (cannot be filed independently by project sponsor)
Preferred Equity ~ Independent (3rd party) manager must approve bankruptcy
Preferred Equity ~ Less risky than common equity position
Preferred Equity ~ Riskier than preferred equity position
Preferred Return Is Not the Same as Preferred Equity
Although the two are often confused, there is an important difference between preferred return and preferred equity. Preferred equity is a position in the capital stack that has repayment priority. Preferred return refers to profit distribution. Profits from operations, sale or refinance are distributed to one class of equity before another. The difference is that preferred return is a preference in the returns on capital, while a preferred equity position is one that receives a preference in the return of capital.
There are many crowdfunding sites that offer preferred equity investments with varying definitions and projected annual returns.
We at Bneevige make a simple distinction that preferred equity position distributions be paid at Projected returns 10% and 18%.
Preferred equity offers investors a more secure, less risky equity position than common equity. And as with any investment, the higher the risk, the higher the projected return.
Both common and preferred equity can be advantageous for both real estate companies and investors. Real estate companies (project sponsors) can increase their leverage — and thus their potential returns — by financing their projects beyond the mortgage by offering preferred equity. This is junior in right of payment to the mortgage debt but senior to the sponsor’s equity. Investors can gain higher returns in exchange for taking on higher risk, a position just one level lower than a first-lien mortgage.
At Bneevige we offer you the opportunity to participate as a prefer equity investor as another way to invest in real estate. Ask us how today.