In commercial real estate (CRE) transactions, financing structures can be complex, incorporating various layers of capital to fund the purchase, development, or refinancing of properties. Preferred equity is one of the less understood but critically important components of these structures. This blog post aims to demystify preferred equity and explain its place within the capital stack, providing insights into how it functions in CRE transactions.

Understanding the Capital Stack

Before we dive into preferred equity, it’s crucial to understand the capital stack, which represents the totality of capital invested in a real estate project, organized by seniority and risk. Typically, the capital stack is divided into four main layers:

Senior Debt: This is usually the first mortgage secured by the property. It has the highest priority in the event of a default and typically comprises the largest portion of the financing. This is the most secure layer, which holds the first claim on the property and its cash flows. Lenders in this position have the highest level of security and the lowest risk, hence, they generally receive a lower return compared to the other layers. 

Mezzanine Debt: This layer fills the gap between senior debt and equity. It is often secured by the ownership interests in the property-holding entity, rather than the property itself.

Preferred Equity: This layer is equity but with preferences over common equity, particularly in terms of cash flow distributions and claims on assets.

Common Equity: The most junior layer, bearing the highest risk but offering the potential for the highest returns. Common equity holders are the last to get paid in the event of a cash flow distribution or liquidation. 

 

The Role of Preferred Equity

Preferred equity is a versatile tool in the sponsor’s financing toolkit, particularly useful in acquisition scenarios where traditional debt might not cover the necessary capital, or where the sponsor seeks to maximize common equity returns. Here are several other scenarios where preferred equity can be leveraged: 

  • Bridging the Equity Gap: When a project faces a shortfall in funding between senior debt and equity raised, preferred equity can bridge this gap. It allows investors to proceed without having to inject more common equity, potentially improving their return on equity.
  • Recapitalizations: In situations where investors seek to buy out existing partners or refinance the property but wish to avoid taking on additional senior debt, preferred equity offers a solution that meet that these objective. 
  • Capital for Value-Add Projects: For properties requiring significant renovation or repositioning, preferred equity can provide the necessary capital that goes beyond the senior debt capacity, allowing sponsors to fund the Capex projects. 
  • Project Rescue: In situations where a project is struggling or in need of short-term capital, bringing in preferred equity can provide the necessary lifeline to help get to stabilization or possibly a refinance into a more favorable long-term debt structure.

 

Preferred Equity Pay Structures

Preferred equity investments come with various pay structures, tailored to balance the risk and return profiles for sponsors and investors. Some common structures include:

  • Fixed Return: Preferred Equity Investors receive a fixed annual return on their investment, akin to interest payments, before any distributions to common equity. The schedule of these payments can be negotiated/structured to meet the needs of the project. 
  • Participating Preferred Equity: Beyond a fixed return, this structure allows preferred equity investors to participate in the residual profits after common equity receives its hurdle rate, effectively sharing in the upside.
  • Convertible Preferred Equity: This structure provides an option to convert preferred equity into common equity, usually under predetermined conditions, giving preferred equity investors the potential for higher returns.

For example, consider a $10 million CRE project with the following capital stack:

  • Senior Debt: $6 million at 4% interest
  • Preferred Equity: $2 million with an 8% cumulative preferred return
  • Common Equity: $2 million

If the project generates $1 million in Net Operating Income, the first $240,000 goes to servicing the debt. The next $160,000 is allocated to the preferred equity holders. If any remains, it goes to the common equity holders. 

In a participating preferred scenario, if the agreed-upon hurdle rate for common equity is a 10% return, and the project performs exceptionally well, and lets say its generating $2 million in cash flow, preferred equity holders could also share in the upside once common equity’s 10% target is met. All these terms are negotiable and can be tailored to the specific deal situation. 

 

Pros and Cons of Preferred Equity

Pros:

  • Flexibility: Preferred equity can bridge financing gaps without the need for additional senior debt, offering sponsors flexibility in structuring deals.
  • Lower Cost of Capital: Preferred equity typically demands a lower total return as it does not participate in the upside, reducing the overall cost of capital for the project and providing higher returns to common equity holders.

Cons:

  • Dilution of Control: Preferred equity investors may require certain controls or decision-making powers, potentially diluting the Sponsor’s control over the project.
  • Increased Financial Obligation: The fixed returns promised to preferred equity investors can put a strain on the project’s cash flow, especially in its early stages or if the project underperforms.
  • Complexity: Structuring and managing preferred equity investments can sometimes be complex, requiring careful negotiation and potentially increasing legal and administrative costs. Also, some of the lenders may not allow Sponsors to insert a preferred equity layer behind the senior debt position.

 

Conclusion

Preferred equity represents a powerful but nuanced tool in the arsenal of CRE sponsors. By understanding its place in the capital stack, leveraging it in various project scenarios, and carefully structuring pay arrangements, sponsors can optimize their financing strategies. However, the benefits of preferred equity must be weighed against its costs and risks. Successful use of preferred equity requires a thorough understanding of its mechanics and a strategic approach to its application, ensuring that it aligns with the overall objectives and risk profile of the project.