The Ins and Outs of Preferred Equity Real Estate

A guide to preferred equity real estate options – discussing, tips and best practices for leveraging capital for your investment.

Understanding the nuances of preferred equity real estate can be a daunting task.

While the preferred equity class of ownership in commercial real estate (CRE) carries more risk than senior debt, this financing structure offers a more secure, less risky position than common equity. Understanding where this financing structure falls in the case of a capital stack is important if you’re looking to put together a commercial property loan.

Let’s examine the advantages and potential pitfalls of this particular commercial real estate financing option.

Preferred equity refers to a type of financing a sponsor or developer will utilize as a component of the aggregate capital raised for a CRE project. While this qualifies as a subordinate financing structure to principal debt, it does qualify as a senior debt when contrasted with common equity.

To fully comprehend the hierarchy of debt, it’s important to know how this equity fits into a capital stack.

Preferred equity is one of four layers of capital that go into purchasing and operating a commercial real estate investment. This capital stack, composed of common equity, preferred equity, mezzanine debt and senior debt, outlines who will receive income and profits generated by a property and in what order.

While common equity is listed first in a capital stack, it holds the lowest priority, and so its lenders are paid last. At the opposite end of the investment structure, senior debt holds the strongest priority, so senior debt lenders are the first to be paid.

The capital stack also clearly outlines who has the right to foreclose on the asset as collateral in the event the equity owner defaults on the mortgage.

Imagine you’re seeking to acquire a building for $50 million. The bank is willing to cover 65% of the total cost, $32.5 million, leaving $17.5 million to be raised. You’ve collected a sponsorship team that has agreed to cover an additional $10 million.

By gathering the other $7.5 million in preferred equity with an 8% annualized return on investment (for example) you can attract family offices, other real estate syndication companies or institutional investors in order to bring the necessary capital to secure your proposed deal.

Your senior lender (in this case, the bank) would be the prioritized payment recipient, followed by your preferred equity investors and then your common equity lenders.

Preferred equity is a commonly used commercial real estate investment option as it forces the sale of the property in the event of a non-payment. Used in tandem with an “equity kicker” – an additional entitlement to profits in the event the project is successful, preferred equity boasts an additional element that similarly structured mezzanine debt does not.

By providing gap funding, seniority to common equity and legal restitution in the event of non-payment, this financing structure remains popular for both the borrower and investor looking to secure commercial real estate financing deals.

Capital and control. They’re the two most important elements of any commercial real estate deal, and you’d like to retain as much of both as possible. This is why preferred equity financing is such an attractive solution for both borrowers and lenders – the terms are clearly defined.

As the borrower, you get to know – to the dollar – what you’ll be paying out to your participants for their contributions. You’ll be able to leverage more capital by offering a clear return on investment for your partners, who will, in turn, appreciate the robust flat annual rate as well as the opportunity to share in the upside of the project via the “equity kicker.”

The exit for your investors is typically held at the point of refinance or upon partial sale, another attractive benefit of preferred equity investments for contributors seeking shorter terms than on the average common equity deal.

Preferred equity real estate investments typically offer annual preferred returns of between 7-12% and total preferred returns (which include the equity kicker or accrued returns) of between 10-15%.

Let’s say you’re looking for investors for your commercial real estate project. Preferred equity offers an accessible way to find investors you might not be able to reach with lenders looking for higher rates of return or greater investing thresholds. It is also generally less expensive than senior debt.

Not being limited to partners and lenders opens new doors to a list of prospective investors looking for security in their CRE deals.

For the investors themselves, preferred equity financing offers a more stable investment with a fixed rate of return. This line of sight makes it a secure option, and may make your offer appealing to those who don’t want to take on the risks associated with other forms of lending. In essence, a preferred equity investor writes a check knowing they’ll receive a predetermined rate of return and the built-in security of both a guaranteed rate of return and the equity kicker bonus incentives.

One potential pitfall to consider if you’re looking to secure preferred equity for your CRE is the relative lack of upside potential for your contributors. If your project performs well, partners in your preferred equity investment will continue to receive their agreed-upon fixed rate of return, but they’ll not be eligible for any additional capital gains outside of the previously agreed upon equity kicker.

This borrowing style contrasts mezzanine financing, which is otherwise similar in terms of providing gap funding, seniority to common equity and legal re-compensation in the case of non-payment. The key difference between preferred equity and mezzanine financing is that the latter functions more like a second mortgage, and will more than likely come from a bank as opposed to the contributions of your various equity holders.

Black Collie Capital is a commercial real estate finance and advisory firm that specializes in arranging and structuring debt, equity, mezzanine financing and C-PACE financing for hotels and multifamily real estate on behalf of developers, investors and owners.

We understand the nuances that can expedite your financing application and can work with you to ensure you’re presenting the best possible terms to attract potential preferred equity investors.

Black Collie Capital can reduce the friction and sticking points often associated with commercial estate deals. We provide both consultative knowledge, advice and – most importantly – the certainty that your deal will receive the consideration it deserves.

Here are the steps we take to ensure your deal allows you to retain the capital and control you’re searching for:

• We assess your real estate capital and create a customized plan to help you access the right capital and funding solutions.
• We offer real estate capital and investment advisory services that handle everything from analysis, deal structuring, underwriting and strategy for acquisition, construction and repositioning of your investment.
• We right-size the information given to the quoting process. By sending the deal to the lender in parts, we keep the focus on the right information at the right time.
• We stay with you. From the strategy planning session to the selection of a project manager for your completed construction project, Black Collie Capital stands beside you for every stage of your commercial real estate investment.

Don’t be overwhelmed by the structure of capital stack commercial real estate financing. Work with a strategic partner who will guide you through the nuances of preferred equity real estate and find you suitable partners for your investment project. Contact us today and experience the Black Collie Capital difference.