Preferred Equity Lenders: A Comprehensive Guide

Preferred equity lenders are a type of investor that provides capital to real estate developers in exchange for a share of the project's profits.

They typically offer more favorable terms than traditional lenders, such as higher leverage and longer repayment periods.

Preferred equity lenders often invest in projects that are too complex or high-risk for traditional lenders, such as those involving historic buildings or environmental remediation.

In return for their investment, preferred equity lenders receive a preferred return on their investment, typically in the form of a fixed percentage of the project's annual cash flow.

Preferred equity lending is a financing tool that has been around for decades, but has only recently emerged in the commercial real estate world. It's similar to preferred stock in the corporate world and is subordinate to all debt, but superior to all common equity.

Preferred equity typically holds the third position in a commercial real estate capital stack, after senior debt and mezzanine debt. It's commonly used in three scenarios: when a mezzanine loan already exists but the sponsor needs additional equity to complete the project; when the senior debt provider doesn't agree to a mezzanine loan for underwriting purposes; or when the sponsor is looking to reduce its own equity in a transaction to increase its liquidity.

A preferred equity holder receives priority distributions after the debt has been serviced, usually with a fixed rate of return over a specified period of time. These distributions can have a regular payment schedule or be structured to accrue.

Preferred equity normally includes an "equity kicker", which is an entitlement to additional profits if the project performs better than anticipated. Notwithstanding a preferred equity holder's subordinated position to debt holders, preferred equity is normally entitled to force the sale of the property in the event of non-payment.

Mezzanine debt and preferred equity are both part of the real estate capital stack, but they serve different purposes. Mezzanine debt is subordinate to senior debt, while preferred equity is subordinate to senior debt but superior to common equity.

Preferred equity lenders offer several benefits to investors. They provide a way to invest in real estate without taking on direct ownership responsibility.

One of the key advantages is that preferred equity investors get repaid sooner than common equity shareholders, reducing their risk in case a deal goes sideways.

Preferred equity investors collect their share of project profits until they meet a pre-determined threshold, ahead of common shareholders earning their dividends.

This can lead to double-digit returns, making preferred equity a highly attractive opportunity for investors, especially in today's real estate climate where prices have continued to climb.

Investing in real estate offers several benefits, including the opportunity to earn double-digit returns. This is especially true in today's real estate climate, where prices have continued to climb.

Preferred equity real estate is a way to invest in real estate without taking on the responsibility of direct ownership. It allows investors to be repaid sooner than common equity shareholders, reducing their risk in the event of a deal going sideways.

Preferred equity investors collect their share of project profits until they meet a pre-determined threshold, ahead of common shareholders earning their dividends. This means they can receive returns sooner than common shareholders.

Investing in preferred equity can provide a more attractive opportunity for investors looking to get into commercial real estate.

Investors who aren't familiar with the complexities of preferred equity deals can be taken advantage of by sponsors who structure deals to benefit themselves.

Sponsors may put together deals that work in their best interests, like soft-pay preferred equity deals, and present them to investors who don't understand the risks.

This can give the sponsor a free option with the preferred equity money, essentially allowing them to benefit from the deal without fully committing.

There are vast differences between types of preferred equity, which can affect investors' rights in significant ways.

Investors should be aware of these differences and take the time to understand their rights before making an investment.

Soft pay terms are more acceptable to lenders because they don't require the operating entity to make payments if there's no sufficient cash flow. This makes it less likely for lenders to have their interests compromised.

In a soft pay scenario, preferred equity holders will only be paid out of the operating entity's cash flow if there's enough to go around. If there's a failure to pay, the preferred equity holders may or may not have remedies they can employ.

Hard pay terms, on the other hand, function more like a debt-instrument, where non-payment can lead to punitive remedies. This can include wiping out all subordinate equity and taking over control of the partnership interest.

Banks don't like hard pay preferred equity positions because they don't want subordinate positions to have the right to take over the operating entity they're lending to.

Mezzanine debt typically has a more straightforward tax treatment than preferred equity, with interest being deducted as an expense and claimed as ordinary income by the mezzanine lender.

One reason borrowers prefer mezzanine debt is that interest is tax-deductible, which can be a significant advantage.

The tax treatment of preferred equity, on the other hand, is more complicated and depends on the deal's structure.

The operating agreement may provide that the preferred equity investor's interest is treated as debt for tax purposes, allowing the sponsor to take interest deductions.

However, this can also make the sponsor liable for cancellation of indebtedness if the preferred equity investor is not paid in full.

Preferred equity lenders structure investments in a way that benefits both investors and developers. They can provide a fixed rate of return, as seen in Example 4, where the preferred equity investor receives a 9% return after the senior debt holder has been paid.

In a typical preferred equity investment, the general partner is responsible for the day-to-day activities, but the preferred equity investor has final approval on major decisions. This is a key feature of preferred equity, as seen in Example 2.

The structure of preferred equity can be "hard" with more debt-like characteristics, or "soft" with more equity-like characteristics. Alternatively, it can be a combination of both. This flexibility allows preferred equity lenders to tailor their investments to meet the needs of different developers and investors.

A common structure for preferred equity investments includes a mandatory redemption date that coincides with the maturity date of any mortgage loans. This ensures that the preferred equity investor receives their return before the developer or general partner.

Here's a breakdown of the typical features of a preferred equity investment:

When seeking mezzanine debt, sponsors often face restrictions imposed by their senior lender. The senior lender typically has the upper hand in negotiations and prohibits certain cures to protect its position.

Mezzanine lenders often have limited rights and cures in the event of default, as outlined in the intercreditor agreement. This agreement is negotiated between the senior lender and mezzanine lender.

Preferred equity is subordinate to all debt, giving the senior debt provider more control over its conditions. The senior debt provider may require a "know-your-client" review for any equity transfer above a certain threshold.

The senior debt provider may also require the original preferred equity investor to retain ownership of a certain percentage of the investment. This ensures the senior lender has some level of control over the investment.

Preferred equity investments have some unique features that set them apart from other types of funding. They are typically structured as joint ventures between the preferred equity investor and the developer or general partner.

In a preferred equity investment, the general partner is responsible for day-to-day activities, but the preferred equity investor has final approval on major decisions. This ensures that the investor has a level of control and oversight.

Preferred equity investors receive regular repayments based on an agreed-upon schedule or structured to accrue. This can provide a predictable income stream for the investor.

A preferred equity investment may also include a "bad boy" guarantee, which holds the general partner personally liable in the event of default. This can provide an added layer of security for the investor.

The structure of preferred equity can be "hard" with more debt-like characteristics, or "soft" with more equity-like characteristics. Alternatively, it can be a combination of both.

Here are the typical features of a preferred equity investment:

The capital stack is the foundation of any real estate investment, and it's essential to understand how it works. At the bottom of the stack, you'll typically find traditional debt, which can account for 60% of the financing. This type of debt is usually offered at the lowest cost and is a sponsor's first choice when looking to secure debt.

The capital stack can be broken down into several layers, with each layer bearing a different level of risk and reward. Mezzanine debt, for example, sits in between traditional debt and equity, and it can earn a higher interest rate due to the increased risk. In some cases, mezzanine debt can even generate equity-like returns with minimal bond-like risk.

Mezzanine debt takes repayment priority over preferred equity and common equity, making it a more secure investment. However, it also comes with a higher interest rate, and the potential return upside is lower compared to investing in equity. The capital stack can be structured in various ways, but a common example is: Traditional debt (60%), Mezzanine debt (10-20%), Preferred equity (10-20%), and Common equity (10-20%).

Here's a breakdown of the capital stack structure:

The capital stack is a delicate balance of risk and reward, and it's essential to understand how each layer works together to achieve a successful real estate investment. By structuring the capital stack correctly, investors can minimize risk and maximize returns, making real estate investing a more attractive option.

Preferred equity can be a safer way to invest in a private equity real estate deal for passive investors, offering a senior position in receiving distributions.

In this scenario, preferred equity provides a fixed rate of return over a specified period of time, along with a share of any upside when the project is sold.

Preferred equity can be attractive through all stages of the real estate market cycle, as payment to preferred equity holders is prioritized.

Real estate developers or sponsors can use preferred equity as a source of capital for large projects that require more funds than what a traditional lender is willing to provide.

By offering preferred equity, developers can avoid borrowing additional money in the form of second or third-position loans.

Hard preferred equity, where the sponsor pledges its own equity in the joint venture to the private equity investor, can be offered by developers with a proven track record of success.

In this case, the preferred equity investor has the right to foreclose on the sponsor and remove it from the project’s ownership structure should the sponsor default.

If you're considering working with preferred equity lenders, it's essential to understand the benefits and drawbacks of this financing option.

Mezzanine debt may appeal to those struggling to raise equity, allowing them to close the gap between the senior lender and common equity.

However, it's still leverage, which means the risk of foreclosure increases with more debt.

Preferred equity, on the other hand, presents a viable alternative, and most lenders require at least 15% of capital in a transaction to be equity.

Here are some key differences between mezzanine debt and preferred equity:

Preferred equity is also a great way for sponsors to increase their liquidity or grow their portfolios, allowing them to retain all upside after serving a preferred return.

Ultimately, the choice between mezzanine debt and preferred equity depends on the nature of the deal and the requirements imposed by the senior lender.