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You would think debt is the engine that drives the real estate market, however, equity also plays a hugely important role. Equity represents ownership, entitling its holders to capital appreciation of assets and to the cash flows remaining after debt service. Equity is yours to raise, keep, spend, or pledge. In this guide, we’ll take a deep dive into preferred equity and the part it plays in the real estate market.
What is Preferred Equity?
It can take the form of stock shares, limited partnership interest, or limited liability units. And, it typically has a high, fixed dividend yield (not unlike interest on debt) that must be satisfied before the holders of common equity can receive dividends. You can picture preferred equity as total equity minus common shareholder equity.
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Preferred Equity vs Common Equity
Preferred equity is a financial tool used by corporations and real estate projects.
Corporate Equity
Preferred equity (“PE”) and common equity are both ownership interests in a corporation. Preferred equity is “preferred” because it receives cash flows ahead of common equity. Often, PE is cumulative. This means that the corporation must fully repay missed preferred dividends before any dividends go to common equity holders. The directors or trustees can reduce, increase, cease or resume common stock dividends as they see fit, but the picture is more nuanced in the real estate market.
Real Estate Equity
We summarize the differences between real estate preferred and common equity in the following table:
Preferred Equity vs Common Equity
| Characteristic | Preferred Equity | Common Equity |
|---|---|---|
| Repayment | Superior to common, subordinate to debt | Subordinate to all other capital |
| Terms | Subject to redemption at a date certain | Paid in full at maturity |
| Return | High fixed rate | Fixed or floating rate |
| Collateral | Direct interest in property | Sponsor’s pledge |
| Bankruptcy | Holders must approve | Independent manager must approve |
| Risk | Less risky than common | Riskier than preferred |
Is Preferred Stock Equity?
Preferred stock certainly is equity, and corporations report it separately from common stock on their balance sheets. Corporations don’t have to pay dividends on either type of stock. That means failure to pay a corporate dividend is not a default, as it would be with debt. If a creditor doesn’t receive repayment on time, it can sue the corporation, seize its assets and liquidate them to recoup its money. Corporate preferred stock holders don’t enjoy this right. However, as we already mentioned, the situation is different in the real estate market, where PE usually can force a property sale when the sponsor or developer misses a dividend.
Preferred Equity in Real Estate
Real estate project sponsors typically take the form of limited partnerships and limited liability companies. In either case, the project has a capital stack representing the financing raised for the project. The stack typically is composed of debt, then preferred equity, and then common equity, in descending order of claim on the project’s assets. Normally, preferred equity holders can force the sale of the project’s property (and other collateral) in the event of nonpayment, but common equity holders cannot. A third-party investor receives preferred equity from the sponsor in exchange for indirect or direct ownership of the sponsor that provides higher priority return on its investment.
Preferred Equity Is Not Mezzanine Financing
Preferred equity differs from mezzanine financing. The latter is secured by the common stock of the sponsor’s company. That means that mezzanine investors can convert their financing into ownership of the sponsor company should default occur. Another feature of mezzanine financing is that it can be issued as zero coupon debt. In this case, the sponsor pays all principle and interest as a balloon payment on the maturity date. You seldom see this with PE. In case of default, mezzanine debt providers can force a quick foreclosure through the Uniform Commercial Code.
Conversely, the company secures preferred equity with the underlying property. On many projects, an “equity kicker” entitles preferred equity investors to additional profit from a successful project. Mezzanine financing packs no such kick.
Sponsors view the risk/reward profile of preferred equity as a hybrid between senior debt and common equity. The senior debt carries the first lien on the property. The common equity has uncapped potential but is subordinate to both debt and preferred equity.
Hard and Soft Preferred Equity
These are the two types of preferred equity:
- Soft PE: Holders receive interest payments only when the project generates enough cash flow. The sponsor applies cash flows first to paying lenders and operating expenses. Soft preferred equity frequently doesn’t have an absolute payment obligation or fixed maturity date. It lacks the strict remedies that hard preferred equity provides.
- Hard PE: The sponsoring LLC or LP makes regular monthly payments of interest to preferred equity investors. The investors can sue if the sponsor doesn’t pay scheduled dividends or repay the equity at maturity, much like lenders can. In this case, investors can seize management control or project ownership.
Preferred Equity vs Common Equity and Debt: An Investor’s Viewpoint
Preferred equity occupies a unique “sweet spot” for real estate investors:
- It provides better upside potential than does senior debt.
- It enjoys payment priority over common equity.
- Its high fixed yield provides downside protection in a bear market.
By owning all three types of capital, investors diversify the risk they accept when investing in a project. Or, investors can choose one portion of the capital stack to suit their own risk/reward preferences. For instance, younger investors might be able to assume the risk of common equity and subordinated debt, whereas near and current retirees might want the fixed yield that senior debt provides. PE occupies a central position that can suit most real estate investors.
Preferred Equity Provides Leverage
You can think of leverage as using other people’s money for your project. Loans are the primary source of leverage, and virtually all real estate projects use debt as the main financing. However, debt will usually cover only 60% to 70% of project costs. Without additional leverage, the sponsor must supply the remaining capital as cash. Sponsors naturally don’t want to tie up their cash in a project when they have better uses for it. They could take on junior debt to increase leverage, but it might be difficult and costly to obtain. Also, your senior lender will insist upon an inter-creditor agreement to protect its rights. This is another obstacle. Mezzanine debt can also add leverage, but it too is expensive and requires repayment.
Therefore, sponsors frequently issue common and preferred equity, in the form of investment units. This raises additional capital, increases leverage and reduces their cash stake. Furthermore, issuing equity doesn’t require an inter-creditor agreement. Both preferred and common each offer benefits to the project sponsor.
Cost of Capital
Debt and equity have their costs. The cost of debt is the interest you pay on the loan. Because its explicitly stated, the cost of debt is easy to identify. The cost of equity is subtler – it is equal to the return that investors require. Preferred equity provides a fixed return, so once again the cost is obvious.
Common equity is different. The dividend doesn’t carry a guarantee – indeed, there might not be any dividend at all. Investors buy common equity to receive income from a property or to earn a share of the profit from the property’s sale. They also can prosper if the equity units themselves appreciate in price. Common equity investors also benefit from potential tax deductions, like depreciation. Depending on the credit rating of the sponsor and the seniority of the debt, the cost of debt might be higher or lower than the cost of equity. If you’d like to get into the weeds, look up the Gordon Growth Model and the Capital Asset Pricing Model. They both help quantify the cost of equity capital.
Reasons to Use PE
These are four reasons why a sponsor might choose to issue preferred equity. The sponsor:
- Might be unable to arrange enough senior or mezzanine debt.
- Seeks to increase leverage beyond the amount provided by lenders.
- Wants to pull cash from the project and replace it with preferred equity.
- wishes to avoid intercreditor agreements with lenders, simplifying the transaction and avoiding closing date delays.
Reasons Not to Use PE
These are three reasons why a sponsor might choose not to issue PE:
- The sponsor can obtain enough loan money.
- Some senior lenders might treat it as subordinate debt, requiring due diligence, underwriting and an inter-creditor agreement.
- Some lenders enforce loan covenants that prevent preferred equity investors from pursuing effective remedies to default.
Mistakes to Avoid When Using Preferred Equity
If a sponsor chooses to employ PE, it should give lenders a chance to evaluate and underwrite the transaction. Failure to allow enough time can lead to closing delays. It’s also a mistake not to realize that some lenders will insist upon underwriting PE financing or that preferred equity investors might not have sufficient recourse should default occur.