Introduction:
Why is preferred equity an excellent commercial real estate investment? Find out the answer here!
Preferred equity can provide a significant advantage to both sponsors and investors. Let’s go over how preferred equity works and the benefits it can offer.
What exactly is preferred equity?
Preferred equity provides active investors with additional funds to complete a real-estate deal. This sort of equity is superior to ordinary stock and ranks second only to senior debt in the capital stack. When profit is realized, or default occurs, the senior debtholder receives payments first, preferred equity, and, finally, common stock.
A real estate illustration of preferred equity
An example best illustrates this topic. Assume a real-estate syndication wants to buy a building for $50 million. The bank is willing to lend up to 70% of the buying price. As a result, the bank contributed $35 million, leaving $15 million to be raised.
The real-estate syndication sponsorship team can obtain $10 million from investors, leaving $5 million to finalize the deal. There are two choices. The first option could be to obtain mezzanine finance, similar to a second mortgage. However, this can be not easy to get at a decent rate and will most likely come through a bank.
Another possibility is to seek $5 million in preferred equity. Perhaps the syndicate could raise $5 million in preferred equity with an annualized return of 8%. That could be lower than a lender, but it should be high enough to entice family offices, other real-estate syndication businesses, or institutional investors to contribute the required funds to acquire the asset.
Preferred equity varies from Common Equity in that specific investors (i.e., a “class of shares”) are given preference in the distribution of cash flows over Common Equity.
In a Preferred Equity transaction, all cash flow or profits are typically returned to the preferred investors (after all debt has been serviced) until they receive the agreed-upon “preferred return,” for example, 12 percent.
The remaining cash flow dividends are returned to Common Equity holders.
Preferred equity is an option for investors looking for a higher-yielding but consistent return. They forego a higher potential total return in exchange for more steady cash flow and lower relative risk.
Importantly, unlike Secured Debt, Preferred and Common Equity reflects ownership interests in an organization but is not secured or have direct access to the asset.
In today’s multifamily housing market, there is a paradox of plenty: there are far too many investors hunting for bargains. Prices are rising due to competition, making it more difficult to earn significant yields. Instead of the high IRRs we’ve become accustomed to seeing when we underwrite potential real estate deals, we’re now seeing predicted returns ranging from 12% to 13%.
However, ownership, or common stock, is risky, so we are turning to preferred equity. Real estate preferred equity investments can provide anywhere from 8% to 15% returns while also providing a protected position that reduces risk and regular income that equals or exceeds the predicted earnings from common equity today.
How? Preferred equity is comparable to preferred equities, which are popular among income investors due to their fixed dividend payments that provide them with income. Although the preferred stock is more expensive than regular, it pays out first—a significant benefit in volatile markets. The same logic applies to preferred equity in private real estate, making it a viable option for investors when rising property prices and construction expenses eat into earnings.
Unlike preferred stocks, which have a specific definition, preferred equity is a broad phrase that refers to various investments. This level of investor has a higher priority than typical equity investors. Their part of income distributions and ownership comes first; therefore, preferred stock sits below common shareholder equity but above debt in the capital stack—the hierarchy that defines whose financial interests get reimbursed first in a private equity real estate deal. If an asset underperforms, this secondary position reduces the risk for investors. Because preferred stock shareholders must be compensated before common equity shareholders, the expected risk and potential reward are lower for preferred equity than for common equity.
Preferred equity, like preferred equities, is often a non-voting ownership share. However, this is changing. For example, “hard” preferred equity is similar to mezzanine financing, giving investors decision-making power. However, “soft” preferred equity may include financial upside if a project performs well. The precise specifications of preferred equity shares, from their rights to their rate of return, are described in investment offering documents and should be studied before investing. When all debts are paid, preferred equity shareholders can collect gains before common stockholders until they reach the goal amount.
A preferred equity position should not be misled with a preferred return, a component of the distribution cascade that prioritizes shareholders above management. The distinction can be perplexing. Preferred equity shares require priority distributions or payment plans comparable to loans, in which preferred investors must be reimbursed regardless of the project’s cash flow status.
Rather than owning a controlling interest in private equity real estate, being a silent partner with a preferred equity position has a risk-reward trade-off. Common shareholders and management co-investors are the first to suffer in a money-losing transaction. Both shareholders expect their money to be returned to an outperforming asset, but common shareholders should be entitled to a higher premium.
Why Have We Selected Preferred Equity?
Lenders typically provide 60% of the capital stack in a preferred equity real estate transaction and earn the right to be repaid first. The preferred equity owner may hold up to 20% of the financing and is the first in line for repayment, with the remaining capital held in common shares. If a $100 million venture loses $20 million due to this capital stack, preferred shareholders obtain full payback of their contributed stock. Common stockholders bear the entire loss.
Of course, neither common nor preferred owners can predict whether the property will underperform or outperform. Both are rooting for victory, but preferred investors are betting against the ordinary shareholder. This can be a good technique in today’s finance industry.
For example, we have a thorough underwriting procedure at our investment company to reduce risk when selecting and structuring projects. Given the risk of loss, we have set an internal target rate of return (IRR) of 13 percent to 15 percent for a controlling common equity position or full ownership. Given current market fundamentals, few properties we underwrite pencil out at that rate of return, but those that do are worthwhile to pursue as a principal owner. In our forecasts, more properties fall just short of such a profit—say, an IRR of 11 percent to 13 percent.
In such circumstances, we consider structuring a preferred equity transaction. The low risk of a preferred equity position will justify the lower return. However, preferred stock investments in our emerging real estate markets can generate IRRs ranging from 8% to 15%. Why wouldn’t we take the offer if putting up preferred equity may provide almost the same or even better returns as owning and managing the property ourselves—with a more protected position?
Partners are not always silent.
Even though preferred shareholders are not management partners, their agreements frequently grant them additional privileges. According to the Chicago-based legal firm Blank Rome, preferred shares typically have a mandated repayment date.
According to Philadelphia-based law firm White and Williams, preferred shareholders may be allowed to veto important choices made by the general partners and foreclose or remove the developer. That isn’t always a good thing because it may create an unexpected burden on the favored investor to take over the administration of a difficult project. On the other hand, Our investment company understands how to own and grow real estate assets. When we invest in preferred shares, this is not our intention, but it provides us with flexibility.
Various broader financial goals lie behind the preferred investor’s risk-reward calculation. Many of our investing partners will willingly forego some potential upside in exchange for more consistent income with less risk. Properties with a high return, such as opportunistic or value-add initiatives, require time to fill vacancies or refurbish units. A steady supply of passive income might supplement a more erratic turnaround project.
However, given the current status of the real estate market, it is less worthwhile to hang out for a larger portion of future profit. Tenants’ budgets are being squeezed. Neither wages nor family incomes are expanding quickly enough to support large rent increases. Valuations are generally reasonably priced, with few exceptions. A 50% annual profit is no longer an acceptable expectation in today’s environment. If returns are expected to vary between 8% and 20%, a protected 8% or 15% is a decent outcome.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.