Preferred Equity Real Estate Investing: What, Why, & How
Preferred Equity Real Estate – Some Background Context
Preferred equity is part of the real estate capital stack – in other words, a type of financing a sponsor or developer will employ as part of the aggregate capital raise for a given real estate project. In short, preferred equity is subordinate to debt, but senior to all common (or JV) equity.
- Preferred equity is a hybrid product, offering a share of upside and payment priority over common equity positions.
- Can be attractive at all stages of the market cycle, but particularly at or near the top of the market.
- Diversifying across the capital stack and staggering hold periods can potentially help to aid long-term growth and mitigate liquidity risk.
Preferred equity is similar to mezzanine debt in function, but slightly different in form. Mezzanine debt functions as bridge financing, but rather than being secured by the underlying property, the sponsor puts up his common equity position as collateral. Preferred equity, conversely, is typically entitled to force sale of property in the event of non-payment. Preferred equity also typically includes an “equity kicker” – an additional entitlement to profits in the event that the project performs well – whereas mezzanine debt does not. In other words, both mezzanine debt and preferred equity provide gap funding, seniority to common equity, and legal remedies in the event of non-payment, but bare some differences beyond that.
A Few Real-World Examples
Preferred equity provides sponsors and developers a higher degree of leverage at a lower cost than common equity (assuming that the project performs well and to expectations). For preferred equity real estate investors, it provides the opportunity to capture a fixed rate return with priority of payment and some upside.
Why Invest in Preferred Equity Real Estate
Preferred equity offers a hybrid risk/return profile. Like senior debt, preferred equity investments carry payment priority over common equity investors and some recourse provisions in the case of borrower default. Like common equity, preferred equity investments typically entitle passive investors to some share of the upside upon exit of the investment – though this upside is capped in preferred equity investments.
Preferred equity investments typically offer a robust flat annual rate of return, as well as the aforementioned “equity kicker” – the opportunity to share in the upside of the project. In many cases (though not all) the exit is projected at refinance or partial sale, making the term shorter than the average common equity investment. Thus, preferred equity real estate investments are attractive for those investors that like the predictable annual returns and regular distributions of a debt investment, and are willing to sacrifice some downside protection in exchange for an additional layer of upside potential – the “equity kicker”. EquityMultiple’s preferred equity real estate investments typically offer current annual preferred returns between 7-12%*, and total preferred returns (including the equity kicker or accrued return) between 10 and 15%*.
Preferred equity real estate investments are also an attractive vehicle for yield during periods in the market cycle when a correction feels likely (many economists have described market conditions as such). Most of EquityMultiple’s recent preferred equity investments have projected to total preferred returns exceeding the typical annual performance of the S&P 500 in recent years, while still offering decent downside protection by virtue of payment priority and rights in the event of a sponsor default.
To summarize, investors find preferred equity real estate investments attractive for the following reasons:
- More upside than senior debt-based real estate investments
- Payment priority over common equity holders
- Downside protection (particularly attractive at or beyond a likely market peak)
Preferred Equity Real Estate Investing vs. Debt and Common Equity
Should you allocate your entire real estate portfolio to preferred equity real estate? Hopefully we’ve made a compelling case for this type of investment, and indeed you may want to devote a substantial portion of your real estate portfolio to preferred equity.
Preferred equity presents another opportunity for portfolio diversification. Investors can mitigate liquidity risk by diversifying across senior debt, preferred equity, and common equity, and by diversifying across hold periods. We encourage investors to consider their overall goals and strategy, – as well as risk tolerance – to inform the precise mix of debt, preferred equity and equity investments in their portfolio.
EquityMultiple allows for investing across the capital stack, enabling investors to achieve this diversification of hold period and risk/return profile.
The basic premise is similar to the “100 minus your age” theorem of stock vs. bonds allocation. (Though that cliche may be more superstition than theory at this point.) While you should reduce the portion of high-upside, high-potential-return investments in your portfolio the closer you get to retirement (and the more risk averse you are to begin with), devoting some of your portfolio to longer-term appreciation and upside will aid the growth potential of the portfolio overall.
By staggering the projected term of your investments, you can put yourself in position to reclaim capital for reinvestment and/or to have more liquid assets on hand.
Postscript: A Note on Today’s Lending Environment
Preferred equity investments held considerable appeal in the quarters prior to the outbreak of COVID-19, as investors sought relatively short target holds and attractive target rates of return amid a low-interest-rate environment and perception that real estate markets were near or at their peak.
As the post-outbreak recovery progresses, the demand for preferred equity financing and other bridge financing may rebound quickly as underwriting standards of traditional lenders tighten.
At EquityMultiple, we are currently keeping our eyes out for potentially interesting preferred equity opportunities. As of this writing, we believe there may be a gap in the market. Specifically, as interest rates rise and the price of assets fall, traditional lenders may not be willing or able to offer loans at the same low rates as they would have previously. Real estate developers and operators will then likely need to find alternative sources of financing–including through market solutions like EquityMultiple.
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