What is Preferred Equity?
Start Your Application and Unlock the Power of Choice$5.6M offered by a Bank$1.2M offered by a Bank$2M offered by an Agency$1.4M offered by a Credit UnionClick Here to Get Quotes!Preferred Equity
Some commercial and multifamily transactions make mention of preferred equity. So what exactly is preferred equity? Preferred equity is a cash flow structure that favors certain investors over others. These “preferred” investors have preference over the common equity distribution of cash flows in the transaction. How this works is once all debt has been repaid, all cash flow or profits are first paid back to the preferred investors up to a previously agreed upon “preferred return,” which is typically measured as a percentage of the cash flow. Once the preferred return is met, then the remaining cash flow is divided among any common investors.
Preferred equity is often reserved for larger commercial real estate deals over $10 million and sits on top of debt in the capital stack. Preferred equity and mezzanine financing can help borrowers leverage a transaction as high as 95% LTC
Related Questions
What are the benefits of preferred equity in commercial real estate?
The benefits of preferred equity in commercial real estate include reduced risks for the investor, a fixed rate of return, and no control over the property. Additionally, soft preferred equity investments typically don't require interest payments (unless the property is generating a significant profit) and often do not require full repayment at a certain date. Preferred equity is also used in commercial real estate and multifamily finance in the case of senior lenders (first lien holders), that don’t allow for subordinate debt debt. It can help borrowers leverage a transaction as high as 95% Loan-to-Cost (LTC).
Preferred equity is often reserved for larger commercial real estate deals over $10 million and sits on top of debt in the capital stack. Most often it will sit on top of a first and second lien and is therefore junior to them. Preferred equity and mezzanine financing can help borrowers leverage a transaction as high as 95% LTC.
What are the risks associated with preferred equity investments?
The risks associated with preferred equity investments depend on the type of investment. With a hard preferred equity investment, the investor is at risk of not receiving their full return if the property owner fails to make payments. Additionally, the investor may be subject to penalties or even lose ownership of the property if payments are not made. With a soft preferred equity investment, the investor is at risk of not receiving their full return if the property does not generate a significant profit.
What types of commercial real estate properties are eligible for preferred equity financing?
According to Commercial Real Estate Loans, hard and soft preferred equity investments are available for a variety of forms of commercial real estate properties. Hard money preferred equity investments operate much like a loan, requiring the property owner to make monthly interest payments and pay the entire investment back by a certain date, regardless of the financial performance of the property itself. Soft preferred equity investments typically don't require interest payments (unless the property is generating a significant profit) and often do not require full repayment at a certain date. Additionally, soft preferred equity investors usually cannot assess penalties against the property owner if they don't pay on time and can't take possession of the property if the owner fails to make payments.
According to Commercial Real Estate Loans, eligible commercial property types for commercial real estate loans and commercial mortgages include retail, office, industrial, multifamily, hospitality, and special purpose properties. Loans from $1M are available for these asset classes.
What are the advantages of preferred equity compared to traditional debt financing?
Preferred equity is a direct ownership stake in a property, whereas mezzanine financing is a form of debt that can be converted to equity in case the borrower defaults. This makes preferred equity a less risky option for investors, as they are not exposed to the same level of risk as with mezzanine financing. Additionally, preferred equity investors may receive an “equity kicker”, an additional equity incentive that allows them to participate in a project’s upside if it reaches beyond a specific financial hurdle. This can be a great way for investors to increase their returns on a project.
Sources:
How does preferred equity financing work in commercial real estate?
Preferred equity financing in commercial real estate is a cash flow structure that favors certain investors over others. These “preferred” investors have preference over the common equity distribution of cash flows in the transaction. How this works is once all debt has been repaid, all cash flow or profits are first paid back to the preferred investors up to a previously agreed upon “preferred return,” which is typically measured as a percentage of the cash flow. Once the preferred return is met, then the remaining cash flow is divided among any common investors.
Preferred equity is often reserved for larger commercial real estate deals over $10 million and sits on top of debt in the capital stack. Preferred equity and mezzanine financing can help borrowers leverage a transaction as high as 95% LTC.
In comparison, a soft preferred equity investment is generally much more lenient. Soft preferred equity investments typically don't require interest payments (unless the property is generating a significant profit) and often do not require full repayment at a certain date. Additionally, soft preferred equity investors usually cannot assess penalties against the property owner if they don't pay on time and can't take possession of the property if the owner fails to make payments. Since they are less likely to reduce a property's cash flow or lead to any changes in the project's management, lenders tend to prefer soft equity deals.