The function of financing in the successful completion of a commercial real estate transaction is crucial. Commercial real estate transactions, however, can access a wider variety of funding choices than their residential counterparts. This abundance of choices can be daunting for inexperienced investors. Investors may not know which sources of financing are best when underwriting a business. This essay will compare two well-known commercial real estate equity investment forms: the preferred stock and the joint venture.
The following are the topics that will cover in detail:
- Preferred Equity: Introduction, Pluses, and Minuses
- Joint Venture Equity: Overview with Benefits and Drawbacks
- Type of Equity: Preferred versus Joint Venture Equity
- Conclusion
Preferred Equity: Introduction, Pluses, and Minuses
Introduction
In commercial real estate, the various funding mechanisms for a deal are referred to as the “capital stack.” The lowest-risk and highest-return debt is senior debt, which includes a permanent mortgage. Ownership interests (common equity) carry the most risk but also the greatest potential reward.
Preferred stock is the second-highest class of equity investment after common stock. Investors in businesses take on more danger as owners than creditors do. Nonetheless, preferred equity usually carries a minimum mandated return that must be paid before expected equity returns. Preferred stockholders benefit from lower risk thanks to this minimum return, but their potential gains are capped.
Benefits
Sponsors and general partners of deals benefit in two main ways from preferred stock financing (i.e., the individual planning and executing the deal). In the first place, once the minimum needed return has been met, preferred equity holders often receive a proportionally reduced return. An agreement can provide an 8% minimum needed return and give the sponsor a grace period to “catch up” to that rate. Above that threshold, the sponsor would earn a larger share of the profits than the preferred stock investors (e.g., the sponsor receives an additional 20 percent of all returns above the catch-up). Promoted interest, or “promotes,” refers to the increased returns for the sponsor.
Second, preferred equity holders typically have little input on a merger’s strategic or operational aspects. This eliminates the problem of having “too many cooks in the kitchen” or many investors providing feedback on a sponsored project. While the preferred stock investors take care of the funding, you can concentrate on what you do best: organizing and executing the deal.
Drawbacks
If the deal is well executed, the promoted interest step should result in the sponsor earning more than the preferred stockholder. However, if the deal doesn’t do well, the promoters might not receive any cash flow. Here, the sponsor gets his initial investment back, whereas preferred stockholders get their full or partial return. If, on the other hand, a transaction included common stock, then the gains and losses would be distributed evenly among all owners.
Joint Venture Equity: Overview with Benefits and Drawbacks
Overview
It takes more than just one company to pursue most commercial opportunities. Partnerships can solve this problem. When two or more companies work together on an endeavor, they are said to be “joint venturing,” and the common equity of the venture is usually split evenly among the participants. Companies often need to work together to complete real estate transactions because (1) they lack the financial resources to do so, or (2) they lack the specialized knowledge to complete the transaction successfully. Joint ventures are formed when two or more companies join their resources to pursue a single business opportunity.
Please be aware that the Internal Revenue Service does not view joint ventures as a valid tax entity. Instead, when companies join forces, they often create a new legal organization (e.g., corporation or LLC). Therefore, this new legal organization would be subject to taxation consistent with IRS regulations. Most commonly, they will use a partnership or corporate structure to determine the tax treatment of a joint venture.
Benefits
Investing in commercial real estate typically necessitates a large sum of money, significantly more than is necessary for a home purchase. One major benefit of this business structure is that it allows these expenses to be split between two or more companies. In addition, you can leverage the knowledge and experience of the other company when you work together. A real estate developer, for instance, might team up with a private equity firm. The private equity firm generates the necessary funds and offers legal services, while the developer provides land and experience. Both sides rely on the other to ensure the transaction goes through in this setup.
Further, in a joint venture arrangement, it is normal for all participants to share equally in the business’s stock. That’s why everyone involved in a business venture has a stake in its success or failure.
Drawbacks
When two or more people start a business together, one or both must give up some control. Joint ventures (as opposed to seeking an investor/partner via preferred equity) require shared duties in an agreement. Also, some real estate investors find joint ventures less appealing because they prefer to handle all aspects of a business independently.
The preceding discussion of common equity highlighted a drawback linked with the control issue. Yes, when you form a joint venture with others, you divide the common equity and, therefore, the risk. On the flip hand, you must also split the deal’s benefits. Suppose the sales profits end up being more than expected. In that case, everyone involved in the joint venture will get a cut of the extra cash (unless an operating agreement specifically says otherwise).
Type of Equity: Preferred versus Joint Venture Equity
Following the preceding, the question becomes: Is it better to invest in a joint venture or acquire preferred stock while seeking capital for a business initiative? Said there is no “right” response. Instead, the answer to this question is conditional on two things: (1) the nature of the agreement and (2) your top priorities.
Joint venture ownership may be an option if the business is too big or complex for one person to handle alone. Taking on a massive project yourself is impossible, but by recruiting partners, you may pool your resources and talents to achieve success.
However, if you want complete say over a transaction but don’t have the cash on hand, preferred shares could be the answer. While these investors provide capital, they typically have little say in operational matters and are just interested in maximizing their return on investment (or expectations). You’re responsible for the strategy and execution of the deal, and the preferred equity partners will receive a return on their investment.
Conclusion
Preferred and joint venture equity both have advantages and disadvantages when used as sources of deal financing. In addition, it should stress that they are not incompatible with one another. Using both preferred and joint venture equity is perfectly acceptable if it serves the purposes of the transaction at hand.
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