If you’ve ever purchased a home, you’re probably familiar with the term “equity” and what it means. When it comes to buying a house, your down payment is the initial equity you have in the property. The rest is financed through your loan with a bank, which you slowly pay off over time.
Unfortunately, commercial real estate is rarely this simple. Because these types of properties cost tens or even hundreds of millions of dollars, they usually require many different forms of financing. Some of the investors will have preferred equity — a financing solution that provides an opportunity to leverage more capital.
This article will explain what preferred equity is, how it’s used, and its pros and cons.
- How Does Preferred Equity Work?
- The “Capital Stack” Explained
- Benefits of Preferred Equity
- Disadvantages of Preferred Equity
- Frequently Asked Questions
- Getting Ready to Invest
How Does Preferred Equity Work?
An equity investment is any amount paid to the property owner in exchange for a stake in that ownership. The two most common types of equity are common and preferred.
Preferred equity is a bit riskier and more costly but generally comes with a higher return on investment (ROI). That means a preferred equity investor will enjoy certain privileges. This may include a priority return on capital or even a higher rate of return.
While preferred equity is superior to common equity, it’s still on a lower tier when compared to mezzanine debt and senior debt. (Keep reading for more on this.) After these top lenders are repaid, the owners of preferred equity will receive their distributions.
The “Capital Stack” Explained
If you’re new to commercial real estate investing, it’s important to know about the capital stack. It refers to the financial organization of a real estate transaction and illustrates which investors/lenders get paid first and which ones take on the most risk. The capital stack can be visualized as a pyramid with four levels — the higher the level, the more risk and potential for reward.
The capital stack also indicates who has more invested in the deal, which may be a key indicator of both risks and rewards.
These are the four levels of the capital stack:
- Common equity
- Preferred Equity
- Mezzanine debt
- Senior debt
Senior debt is at the foundation of a transaction, providing low risk and low return. They will be paid first as they are typically the mortgage lender or another debt holder.
Likewise, the mezzanine debt holder is next. This line of debt is similar to taking out a second mortgage on a home. At the top of the stack is where you’ll find preferred and common equity — tiers with the expectation of high risk, but the potential of high profit.
Understanding your position in this stack will help with your decision-making, increasing your comfortability and profitability when it comes to a transaction.
Benefits of Preferred Equity
Like any real estate transaction, there are pros and cons of various types of investing. First, let’s discuss some of the advantages of preferred equity.
In addition to giving investors a way to partake in a transaction without direct ownership, it generally provides faster repayment than common equity. In general, this may shield an investor from losses in the event of a sale or liquidation because they’re receiving their returns at a quicker rate.
As previously mentioned, it also typically provides higher ROI and a level of priority over common equity investors. Preferred equity comes with certain preferences that are determined on day one.
Disadvantages of Preferred Equity
What are the downsides of preferred equity?
Increased risk is perhaps the most important thing to consider. There is usually more money invested with little control. Senior lenders and property owners will have more leverage when it comes to the details of a transaction. As is the case with most real estate investments, there is always a chance for losses.
Preferred equity investments also offer less liquidity than common equity because it can be harder to sell your stake. Due to the nature of preferred equity, fewer people will be willing to take on the risk.
Frequently Asked Questions
Why is preferred equity important?
For a company or individual trying to build commercial property, preferred equity allows for the necessary capital without taking on more debt. Because anyone can be a preferred equity investor, it opens up a new level of potential. In short, it’s a flexible method of fundraising that removes the need for additional financial institutions.
Investors also enjoy a few benefits when it comes to preferred equity. For example, the fixed rate of return allows for a secure strategy in most cases.
Are there any requirements for preferred equity investing?
Every investment opportunity is unique, but there are usually requirements or guidelines set forth.
In most cases, you need to be accredited. This is a way of ensuring you have the financial capability to participate as a preferred equity investor. You may have to meet a minimum annual income amount or show proof of certain net worth.
Aside from these elements, most transactions will require an investment of at least $100,000, but again, every situation is different. There are no hard and fast rules.
Is this type of investing considered safe?
Investing is never a sure bet, regardless of how favorable the market is. That means preferred equity isn’t necessarily “safe.” It offers a more secure option than common equity, but as you may know, higher risks are usually associated with higher rewards.
Before you decide to invest, consider your financial security and whether you’re in a position to essentially gamble with your money. This will help you determine whether preferred equity investing is right for you.
Getting Ready to Invest
Investing in commercial real estate doesn’t have to be intimidating. If you’ve bought a home before, you already have some experience working with real estate professionals and scouring the market for properties. Commercial real estate is just the next step — more complex but possibly more lucrative. As a result, it’s especially helpful to have a complete understanding of the concept and terms of the deal before participating in preferred equity investment.