We recently paid off our preferred equity in a multifamily deal. Preferred equity is a powerful tool for both investors and syndicators. In this article, I’ll explain what preferred equity is, where it’s used, and what to look out for.
But first, let’s cover what a capital stack is. Check out this article for more information.
What is preferred equity?
Preferred equity (or “pref equity”) is a form of financing that sits between common equity and debt in terms of priority and risk. It provides investors with a higher level of priority than common equity in the distribution of cash flow and proceeds from the sale of the property.
Unlike debt, preferred equity does not require regular interest payments or principal repayment, but instead provides investors with a fixed or variable rate of return. Preferred equity is typically used in real estate syndications to provide investors with downside protection and more predictable returns, while still offering the potential for upside if the property performs well.
Because it provides a higher degree of downside protection, it is usually capped on the upside as well.
Here’s an example from our deal. We offered two classes of shares to investors:
Class A Shares: 12% preferred return with no upside; paid monthly, with priority in cash flow and capital events over Class B Shares
Class B Shares: 9% preferred return + 50% split of cash flow and profits above the preferred return. Paid monthly, but sits in last position of the capital stack. Projected IRR of 20%.
As you can see, Class A is the preferred equity and Class B is the common equity. If there is cash flow, then the Class A shares get paid first and in full before Class B receives a penny of cash flow. If there is a capital event, like a refinance or sale, then Class A investors will receive their invested capital back first before any equity is distributed to Class B.
(Note: There’s never a ‘one size fits all’ rule for syndications; they are all different. Make sure you read the legal docs for your deal.)
Why Is Preferred Equity Used in Syndications?
Let’s examine why both GPs and investors are drawn to pref equity.
Why GPs like Pref Equity:
Deal structuring: Preferred equity can help sponsors to structure deals that might not be feasible with traditional debt or equity financing. For example, preferred equity can be used to fill a gap in the capital stack between senior debt and common equity, or to provide additional leverage without diluting the ownership stake of the sponsor.
Attracting investors: Preferred equity can be an attractive investment option for investors who are looking for a more predictable return on their investment than they might get with common equity, but who still want to participate in the potential upside of the property. By offering preferred equity as an investment option, sponsors can attract a wider range of investors with different risk profiles and investment objectives.
Like debt, it’s a great way to “lever up” returns for common equity investors and general partners that feel confident that the deal will support it. Preferred equity is normally a small part of the total equity offering; 10-30% is typical. Sometimes it isn’t even offered. If the GPs have a high degree of confidence that the deal will meet or exceed projections, then it makes sense to pay investors a 12% fixed rate when they know the deal will produce 20% returns.
Why Investors like Pref Equity:
Downside protection: Preferred equity has priority over common equity in the distribution of cash flow and proceeds from the sale of the property. This means that if the property underperforms, preferred equity investors are more likely to receive a return on their investment than common equity investors. This downside protection can be particularly attractive to investors who are looking for a more stable, predictable return on their investment.
Predictable returns: Preferred equity typically comes with a fixed or variable rate of return that is paid before any distributions are made to common equity investors. This provides investors with a more predictable stream of income than they might get with common equity, which can be subject to fluctuations based on the performance of the property.
Risks and considerations associated with preferred equity:
Don’t be mistaken by the parallels drawn between debt and preferred equity. Pref equity is still equity, and there is risk for loss of principal. Unlike debt, preferred equity does not have a fixed maturity date, which means that investors may not receive their principal back for a long time. Additionally, if the company experiences financial difficulties or goes bankrupt, preferred shareholders may not receive their full investment back, as they rank lower in the capital structure than debt holders.
Like common equity, another risk is the lack of liquidity. Preferred equity investments are typically illiquid, which means that investors may not be able to sell their shares easily or at a fair price. This can make it difficult for investors to exit their investment when they need to, which can be particularly problematic if they need to access their funds urgently.
There’s also added risk/reward for common equity when there is preferred equity in a deal. Some investors will not invest in common equity if there is preferred equity; they do not like the added risk that comes with being lower in priority on the capital stack.
For me, I would rather invest in common equity as a LP; even if there is preferred equity on a deal. I’m comfortable with the added risk, especially if I’ve already vetted the sponsor, the business plan, and the market. But it all depends on your specific goals- there are many that prefer the added security and fixed rate of return that is provided through preferred equity.
