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Money

Preferred vs. Common Equity

By Eli Moghavem, Base Equities

Preferred equity is an equity investment that has payment priority over common equity (what most typically think of as equity). The preferred equity holder will be paid the first dollars of cash flow after repayment of debt from property operations and gets paid on a sale or refinancing before the common equity owners.

Here is a visual representation of the capital stack with preferred equity. In this case the total capitalization (purchase price, plus closing costs, plus cost of any improvements) is $15,000,000, and the preferred equity holder has payment priority over $3,000,000 of common equity. In practice this means that for the preferred equity holder to suffer any losses, the property would have to sell for $12,000,000 – a 20% decline in value. This safety margin makes preferred equity more insulated from loss than common equity.

So why would a real estate sponsor agree to preferred equity and have their equity (and that of their investors) paid last? In general, preferred equity has more favorable financial terms to the sponsor, assuming the property meets or exceeds its business plan. With a higher percentage of the profit participation (or in some cases all of it) going to the sponsor, preferred equity can significantly increase the rate of return on common equity.

In addition, sponsors often want to limit their equity investment into a deal (or have limited funds) and lenders will in most cases not allow financing alternatives such as mezzanine debt. Mezzanine debt often comes with full personal guarantees or equity pledges that sponsors do not wish to be exposed to. In the case of a “home run” deal for the sponsor, preferred equity will allow them to retain a larger portion of the profit participation than most common equity investors will accept. Sponsors need not risk damaging established investor relationships by renegotiating improved profit splits in their favor when preferred equity can often provide this. 

From an investor’s perspective, as displayed in the above graphic, preferred equity provides access to real estate investments with an attractive risk-adjusted return. Typically, preferred equity investors receive a minimum current return as well as additional returns through an accrual rate and/or profit participation when the property is refinanced or sold.

Additionally, preferred equity is structured with certain control rights in the operating agreement that allows the preferred equity investor to take control of the project in case of any material issues in advance of a lender foreclosure and thus provide an opportunity to correct any issues and maintain the property’s value. Common equity investors usually do not have these rights meaning that preferred equity usually provides substantially better protections to investors. 

For the right transaction, using preferred equity is a win-win for both sets of investors: preferred equity investors can get attractive risk-adjusted returns and common equity affords those investors greater upside with higher loss exposure. 

Base Equities is a nationwide provider of preferred equity specializing in small balance transactions where the preferred equity investment is between $1 million and $5 million. 

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