Understanding Preferred Equity

Preferred equity is a unique method of financing that is traditionally used when funding commercial real estate, private equity funds or crowdfunding investment opportunities. Like the stock market, when investing in commercial real estate, preferred equity investors want to increase their passive income while managing and reducing their risk. 

Preferred equity is commonly used as a method of real estate financing that allows developers to add to their “stack” of financers. This goal can be accomplished by offering equity to participating investors or sponsors rather than taking on additional loans from banks or lending organizations. 

What Is Preferred Equity?

Preferred equity is most commonly used when developers acquire funding for significant commercial real estate investments. In addition, this capital structure is commonly used when additional funds are needed to secure or make changes to a real estate investment. Rather than borrow more money from public lenders, developers can offer preferred equity with a fixed rate of return to participating investors. 

In this structure of real estate financing, the private lender gets priority repayment positioning from any profits earned from the investment. As a result, the active lender remains ahead of any participating investors, preferred equity investors or sponsors. However, the lender is not ahead of the senior lender, those providing a first or second mortgage from a bank or lending institution. 

The preferred equity investors earn preference shares that come with a higher return on investment (ROI) than senior lenders such as banks or lending institutions. 

When Do Developers Need Preferred Equity Investors?

Securing the Final Mile of Funding

One common reason developers would need to seek out preferred equity investors is to secure the last mile of funding the bank didn’t offer. For example, suppose a developer is $300,000 short of the downpayment needed to purchase a $1 million apartment building. In that case, they can choose to offer preferred equity to investors to secure the final funds necessary to buy the property. 

Renovations not Covered by the Initial Loan

Likewise, preferred equity can be offered in purchasing an add-value property, where additional renovations are needed to increase the property’s value and thus the ROI. 

Where the senior lender may only be willing to offer a loan to purchase the property itself, preferred equity investors could be used to raise funds for renovations so that the ROI is higher when it comes time to sell the property. 

An example of this process would be if a bank granted a developer $5 million to purchase a suburban condo complex. Although the properties are in good shape, the developer could rent out each condo at a higher monthly rent if they were renovated to include luxurious modern-day amenities. 

The developer can choose to offer preferred shares of the commercial real estate investment to preferred equity investors. By doing so, the developer raises an additional $1 million to renovate each condo, ensuring a higher ROI for all parties invested in the condo complex. 

Addressing Unforeseen Challenges

An additional example of when a developer would offer preferred equity is if unforeseen changes arise to increase the value of an existing property. The flexibility provided by preferred equity investment models allows projects to continue where the development team would otherwise be halted. 

To look at a hypothetical example, a $20 million penthouse was built in 1995. The development team decides to bring modern-day amenities to the property. After raising the necessary funds by offering preferred equity, the development team completes the renovations. The property then sells for $30 million, increasing the ROI on the penthouse. 

Benefits of Preferred Equity Investments

Financial Flexibility 

Developers access many built-in benefits with the preferred equity investment model of financing. Offering preferred equity in real estate financing often gives developers financial flexibility they otherwise wouldn’t have the luxury to use. Developers can decide when they’d like to offer preferred equity to complete or purchase commercial real estate properties. 

Guaranteed and Timely ROI

Developers can raise equity from preferred participating investors, knowing for a fact that their investors like their rate of return. Investors with preference shares typically have a higher rate of return than those in the position of lenders or sponsors, which carry a higher degree of risk. 

The majority of preferred equity structures offer fixed rates of return over an agreed-upon period, typically 1 to 5 years. The majority of commercial loans are for shorter terms like 5 to 10 years. Because of this timeline, the sponsor commonly refinances or liquidates the property in a period of fewer than 10 years. 

When a sponsor liquidates their property, they repay their debts to senior lenders and preferred equity investors in a timely fashion. Additionally, a percentage of shared equity may be included in preferred equity structures. This aspect allows preferred equity investors the chance to earn money if the property’s value appreciates over the time they’ve been an investor. 

Are Preferred Equity Investments Risk Free?

In every investment, investors experience some degree of risk. The same can be said about preferred equity investing. While there is an excellent opportunity to increase passive income from preferred equity investments, an assumed risk exists. 

In the unfortunate event of a bankruptcy, a preferred equity investor has a chance to receive compensation in a judgment. As a preferred equity investor, your preferred stake would be considered if there were to be a judgment paying capital back to investors in the project. 

Do Your Homework

It goes for any investment you may be considering that investors should do the appropriate research before placing their money and confidence behind a project. A preferred equity investor should always be aware of the reputation and track record of the development team before choosing to invest in a commercial real estate.

By doing your own research before investing, you will manage the assumed risk of investing in a commercial real estate project. 

Who Should Invest in Preferred Equity?

This opportunity can be a tremendous hands-off investment for people who can’t or don’t want to commit to commercial real estate development projects outside of financial investment. Commonly preferred equity investments have an agreed-upon rate of return, assuming the project doesn’t go south.  

Someone who wants to make money and ensure a guaranteed return on investment while not taking on the responsibilities of a sponsor should consider investing in preferred equity. The sponsor has a far greater responsibility, working hands-on with building managers, maintenance and renovations to ensure the property’s equity and investment.

Benzinga’s Best Real Estate Investment Platforms

Preferred equity can truly be an excellent investment for those looking to manage their risk while earning passive income. If you’re interested in looking at preferred equity investing opportunities, check out Benzinga’s favorite platforms below: 

Preferred Equity: What’s the Big Picture? 

Ultimately, preferred equity offers many benefits to both preferred investors and project developers alike. 

For those considering preferred equity investing opportunities, it allows investors the chance to minimize risk while increasing passive income. In addition, preferred equity investors don’t have to partake in any of the hands-on work needed to solidify a successful real estate investment. 

The security offered to participating investors allows active investors, like developers or sponsors, the flexibility to leverage more capital as they see fit. The additional funds secured through preferred equity investors can be used to purchase properties, upgrade existing projects or address unforeseen changes in a real estate project. 

Make sure to return to Benzinga for important updates regarding preferred equity investment opportunities. 

Frequently Asked Questions

Is preferred equity considered debt?

No, preferred equity is not considered a debt that needs to be repaid. Similar to common stock, preferred equity is, as its name suggests, equity in an investment opportunity. While developers have a responsibility to honor preferred shares, they do not have an obligation to pay preferred equity investors if the real estate project is not profitable. 

How is preferred equity treated?

Although preferred equity has many characteristics and behaviors similar to a bond, preferred equity is treated as equity in an investment opportunity. Therefore, those who choose to take part in preferred equity investments need to be aware of the assumed risk in this kind of investment.