Preferred equity in its broadest sense is an equity investment that has preference over common equity for cash flow distributions. It has a position in the capital stack between the senior debt and common equity in a real estate investment, meaning that distributions and return of capital to the holders of a preferred equity investment are subordinate to the senior debt, yet have priority over the common equity holders. As such, preferred equity is sometimes seen as a hybrid of debt and equity products.
Given its position in the capital stack, preferred equity receives a higher rate of return than senior debt and a lower return than common equity, which is correlated to its relative risk profile. Sitting ahead of the common equity adds a layer of loss protection to holders of preferred equity. Since common equity is the last to get paid, they will be impacted by losses prior to preferred equity holders. However, foregoing the level of risk that common equity incurs also limits the potential upside; consequentially preferred equity returns can be capped.
Similar to a loan, preferred equity has current interest payments that must be made to the preferred equity holders regardless of the cash flow produced by the underlying real estate, referred to as a current return. Additionally, there can be an accruing interest payment, referred to as an accrued return, which is distributed to the preferred equity holders at a later date or upon maturity. Preferred equity holders usually possess some sort of transfer rights, whereby a transfer of control of the underlying real estate can be forced from the common equity holders to the preferred equity holders if certain defaults occur. Fixed redemption dates are also common, at which time the outstanding preferred equity balance must be repaid, again regardless of property cash flow.
So why would a sponsor want to include a piece of preferred equity in a capital stack? One reason could be an inability to secure a desired amount of leverage from a senior lender. As lenders become more conservative in their underwriting, they may be less willing to lend at higher levels of leverage. In times of heightened uncertainty, such as the current COVID-19 environment, this lender conservatism can increase given hesitation around tenants’ future ability to pay rent. As a result, preferred equity deals can become more popular when lenders increase their leverage constraints.
Certain senior lenders also have restrictions on junior mortgages being placed on properties. For example, commercial mortgage-backed security loans typically do not allow for subordinate debt, such as a mezzanine loan, to sit below them in the capital stack. Given these restrictions, adding a piece of preferred equity to the capital stack can be an attractive way to increase an investment’s leverage.
Although preferred equity is more expensive to a sponsor than traditional senior debt, the incremental increase in leverage provided by preferred equity is typically accretive to a deal’s returns, albeit at an increased level of risk.
For investors, there are times when it makes sense to be invested in preferred equity or common equity. Preferred equity investments can be perceived as safer investments when compared to common equity given the seniority in receiving distributions. While preferred equity investments are not collateralized by the real estate directly like a senior loan, they do often have transfer of ownership rights and are secured by the common equity interest in the property. In the event of a sponsor default, this transfer right allows the holders of preferred equity the chance to step into management of a venture and cure such defaults. In addition, preferred equity investments can offer investors a regular stream of income even when a property is not cash flowing. In challenging financial times, a preferred equity investment can make sense given the possibility for higher returns compared to the senior debt along with an increased level of downside protection compared to common equity.
On the other hand, common equity may be a better option for investors looking for uncapped upside and longer term investments. While common equity investors can see significant upside if the investment performs exceptionally well, preferred equity investors will only receive the interest payments they agreed to — no matter how well the underlying property performs. Additionally, while preferred equity investments may see hold periods of five to 10 years, as is typical of common equity, they often have shorter two- to five-year horizons at which point they are paid off and no further financial benefit is received.
Understanding the benefits of different types of investments when making product selections and matching such products to investor goals is crucial. Product type should not be viewed in isolation, but rather evaluated congruently with the deals underlying assumptions and market fundamentals.
ArborCrowd continuously monitors and evaluates potential preferred equity offerings in an effort to identify the best investment opportunities for investors. The firm’s experience as an institutional investor in real estate makes it uniquely positioned to find quality deals with top of the market sponsors.