If you've been involved in the world of real estate development, chances are you've come across the term "preferred equity." This type of financing is commonly used to fund real estate projects. But what exactly is preferred equity in real estate financing? What are the advantages and disadvantages of preferred equity investments? And what do lenders look for in preferred equity real estate deals? In this article, we will provide answers to these questions and more.
What is Preferred Equity Real Estate Financing?
Preferred equity is a term frequently used by investors, capital providers, and real estate developers. It refers to a broad category of investments rather than a specific form of financing. In simple terms, preferred equity involves a partnership where the partner's interests take priority over others, known as "common equities," when it comes to cash flow and equity distributions.
Unlike common equities, preferred equity investors receive distributions of cash flow and profits before other parties, based on a fixed annual rate. These distributions are paid until the preferred equity investors have received the full agreed-upon amount. It's important to note that preferred equity investors have an ownership interest in the company, but their ownership is unsecured, and they do not have direct recourse to retrieve company assets like secure debt holders.
What is Preferred Equity in a Real Estate Deal?
In a real estate context, preferred equity in a real estate deal can be highly beneficial. While it shares similarities with mezzanine debt, preferred equity has unique characteristics. Unlike mezzanine debt, preferred equity can be used as leverage to force the sale of a company if payments are not made. Additionally, preferred equity often entitles the investor to earnings if the project generates net profit, whereas mezzanine financing does not provide such entitlement.
Preferred equity and mezzanine debt both offer "gap funding," which provides quick access to funds for projects or ongoing operations. They also offer preference over common equity and legal recourse if payments are not made. However, they differ in their specific functions and funding options.
Pros and Cons of Preferred Equity Investments
Preferred equity investments have gained popularity in the real estate market in recent years as an alternative to securing subordinate or mezzanine financing. These investments have allowed developers and real estate owners to raise the necessary capital for property purchases, development, and renovations. However, preferred equity investments share similar rewards, uses, and risks with mezzanine and subordinate financing.
One significant advantage of preferred equity investments is their ability to accommodate changes in controlling interests and available resources. On the other hand, the diverse forms of preferred equity investments make it challenging to determine the best solution for specific real estate developments or deals.
How Preferred Equity Investments are Structured
The structure of real estate preferred equity investments varies depending on several factors. Generally, deals involve a single third-party making an investment and receiving an ownership stake in the real estate owner. This stake entitles them to a priority position in terms of return on investment, ensuring they receive a payout before other investors with common equity.
One common structure is similar to a loan, where the investors receive monthly interest payments and penalties if payments are delayed. This structure is known as "hard" preferred equity. Alternatively, a "soft" preferred equity structure may not require monthly interest payments, have a determined date of maturity, or impose intense remedies for delayed payments.
What Lenders Look for in Preferred Equity Real Estate Deals
Lenders generally seek a stable set of conditions when considering a preferred equity real estate deal. Some common conditions include loan values ranging from $1 to $40 million, terms lasting up to approximately one year, interest-only payments, and considerations for specific asset classes such as industrial, commercial, and mixed-use properties. Preferred equity can be used for restructuring, value-added projects, recapitalization, and leveraged buyouts.
While this is not an exhaustive list, lenders often consider these factors before proceeding with a preferred equity real estate financing deal.
Preferred Equity Real Estate Example
To illustrate a preferred equity financing situation, let's consider a scenario where a real estate company aims to purchase a $40 million apartment complex in Ohio. They require additional funds and preferred equity to complete their capital stack, including value-added propositions.
In this case, a lender might offer a $10 million piece of preferred equity, an 80-20 ownership split, and a 5-year investment term. This arrangement allows the real estate developer to execute their plan, invest in the property, and retain cash reserves for other essential projects.
How to Read a Real Estate Preferred Equity Term Sheet
A real estate preferred equity term sheet is not a legally binding document but serves as a written agreement outlining the expectations of both parties involved. It details the structure of the deal, specific terms that must be met, equity distribution among investors, and other crucial information. The term sheet covers elements such as the closing date, investors and investment amounts, amount raised, property valuation, and additional provisions such as dividends, liquidation preferences, voting rights, and more. A detailed term sheet minimizes the likelihood of disputes between involved parties.
The Difference Between Preferred Equity and Common Equity
Preferred equity, also known as "preferred stock," takes precedence over common equity. Owners of preferred stock receive payouts before other shareholders and have greater claim to company assets, earnings, and profits. This distinction makes preferred equity a more attractive option for investors looking for security and prioritized returns.
Navigating the world of preferred equity in real estate can be complex. The commercial mortgage brokers at Clopton Capital specialize in guiding clients through the process of securing preferred equity funding and achieving their real estate goals. Contact us today to learn more about preferred equity options through Clopton Capital.