Preferred equity is a hybrid between debt and equity. Like debt, preferred equity has priority over common equity, earns a fixed rate of return; but like common equity, it subordinates to the senior loan. Pref equity investors receive priority on both distributions and return of capital over common equity investors.
As the interest rate rises and anticipation of recession around the corner, many real estate investors either switch to debt strategies to lower their risk or just sit on their cash waiting for the market to improve. However, preferred equity can be a great alternative solution that would provide investors with the ability to earn an attractive risk-adjusted return with a significant number of inbuilt downside protections that work to lower risk.
Preferred equity is typically structured with all, if available, or a portion of the interest payment requirement to be made monthly or quarterly, similar to regular debt service, and with the rest of it accrued to be paid off when there is sufficient cash flow.
Preferred equity is quite similar to mezzanine debt. Mezz loans are subordinate to senior debt but have priority over both preferred equity and common equity. However, preferred equity investors have direct ownership of the asset or borrowing entity, mezz lenders hold a pledge of investment’s equity as collateral. And since mezz debt only holds a pledge as collateral, no tax benefits flow to them.
In summary, the preferred equity structure offers investors a combination of benefits such as:
1) Current cash flow
2) Downside protection.
3) Fund level diversification and professional due diligence (if investing through a fund)
An example of a preferred equity term is something like this –
An investor invests $1,200,000 in a project that offers 15% preferred return, 10% will be paid out of monthly cash flow, and 5% accrual. The investor will receive a monthly cash flow of $10,000 (($1,200,000 *10%)/12) and a deferred payment of $60,000 ($1,200,000*5%) per year to be paid out at re-finance or sale of the asset.
Investments made into a preferred equity fund, rather than in one property, provide added risk mitigation to investors. The current cash flow is typically distributed to investors on a monthly or quarterly basis and is a combination of the entire fund portfolio versus one property. If one of the properties in the fund fails to pay the current preferred interest payment, and the reserve is insufficient to cover the gap, the cash flow received from the other properties can be used to make a distribution to investors. This is why investing in a fund secures monthly cash flow and mitigates risks for investors.
Preferred equity also offers downside protection for investors. As mentioned above, preferred equity investors are only subordinate to the senior debt. That means they always get paid first before the common equity investors. The common equity investors are always the last group to receive capital and distribution back (the sponsors are in this group). This pay structure keeps the sponsor motivated to successfully carries out the business plan so that they can get paid.
By following a diverse allocation strategy, fund managers can ensure that their investments are allocated across many different locations, asset types, sponsors, and strategies. This diversification ensures that if one region, asset type, or sponsor is adversely affected, it will have a limited impact on fund returns as it comprises a small part of the overall portfolio.
Preferred equity offers many benefits to investors. Only subordinate to senior debt, preferred equity investors are the first to get distributions and their capital back before the common equity investors and the sponsors. Preferred equity investors benefit not only from the current cash flow but also from the downside protection. They are even more insulated when investing in a preferred equity fund because the fund diversifies the investment in multiple assets and sponsors.
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