Preferred equity is an alternative form of financing commonly offered by private equity groups, or investment funds to be used in commercial real estate investments. Many general partners seek out preferred equity on commercial real estate investments because it reduces the amount of capital they’re required to bring to the table and can have a favorable impact on returns
It is important to understand the different layers of financing, referred to as capital stack. The layers that make up a capital stack are senior debt, mezzanine debt, preferred equity, and common equity. Generally all four components are not used concurrently, but it is useful to understand how each layer is prioritized when it comes to receiving returns.
The first to be paid is senior debt, which is the loan made by the bank or lender. If used, mezzanine debt would fall right behind senior debt, and would only come into play to displace some of the capital that would normally be invested from an equity partner. Preferred equity sits on top of all debt in a capital stack. This means that preferred equity investors will receive the highest priority regarding repayment after debt has been paid. Before the general partners or common equity investors can make any profit from the property, preferred equity investors must be paid. Although general partners and common equity investors are subordinate to all others in the capital stack, they are the ones reaping the greatest returns.
The main differences between debt and equity in a capital stack are risk and returns. Senior debt is the least risky option, however this also means that the bank/lenders have no chance for profit participation. Preferred equity, while more risky than debt, tends to be less risky than other forms of equity. Preferred equity has higher returns than debt to compensate for the added risk, but lower returns than common equity and limited profit participation.
When it comes to investing in commercial real estate, risk is often coupled with higher rewards. Investors must decide if the risk/return profile makes sense when compared with the risk tolerance and return expectation of the investment. In terms of risk, preferred equity is not as safe as senior debt, however, it is not as risky as common equity.
If you are an investor seeking creative options to structure your capital stack, preferred equity investing is worth looking into.