Real estate investing can be a lucrative endeavor, but it can also come with its fair share of risks. One way to mitigate these risks is through preferred equity investments.
Here is everything you need to know about preferred equity in real estate.
What is Preferred Equity?
Preferred equity is a type of investment that sits between debt and common equity in a company’s capital stack. It is a hybrid instrument that has characteristics of both equity and debt. Preferred equity investors receive priority over common equity investors when it comes to distributions, but they have lower priority than debt investors when it comes to repayment in case of default.
In real estate, preferred equity is often used to finance a project’s capital needs, such as construction or acquisition costs. The investor provides the capital in exchange for a preferred equity stake in the property. The preferred equity investor typically receives a fixed or variable return on their investment, as well as a priority in receiving distributions from the property’s cash flow.
How Does It Differ From Other Types of Real Estate Investments?
Preferred equity differs from other types of real estate investments, such as debt and common equity, in a few key ways.
Preferred equity investors have priority over common equity investors when it comes to receiving distributions from the property’s cash flow. This means that preferred equity investors are more likely to receive regular payments, even if the property is not performing as well as expected. They also typically have a fixed or variable return on their investment. This means that their return is predetermined, unlike common equity investors who share in the property’s profits but also bear the risk of losses.
Preferred equity investors also have a lower priority than debt investors when it comes to repayment in case of default. This means that in the event of a foreclosure or bankruptcy, debt investors will be paid back before preferred equity investors.
What Are the Advantages of Preferred Equity Investments?
There are several advantages to investing in preferred equity in real estate.
Preferred equity investments can provide a steady stream of income. Preferred equity investors typically receive regular payments from the property’s cash flow, which can be especially beneficial for investors who are looking for a reliable source of passive income. They can also offer higher returns than traditional fixed-income investments, such as bonds. This is because preferred equity investors typically receive a higher return than debt investors, but their investment is less risky than common equity investments.
Another prominent benefit of preferred equity investments is that they can provide a level of diversification to an investor’s portfolio. By investing in preferred equity in multiple properties, an investor can spread their risk across a variety of real estate investments.
What Are the Risks of Preferred Equity Investments?
Like any investment, preferred equity in real estate comes with risks. Some of the risks of investing in preferred equity include:
- Market risk: The value of the property can fluctuate based on market conditions, which can impact the investor’s return.
- Liquidity risk: Preferred equity investments are not as liquid as other investments, such as stocks or bonds. It can be difficult to sell the investment quickly if needed.
- Default risk: In the event of a foreclosure or bankruptcy, preferred equity investors have a lower priority than debt investors when it comes to repayment.
- Property-specific risk: The success of the investment is dependent on the performance of the specific property, which can be impacted by factors such as location, tenant demand, and property management.
By doing your research, seeking advice from experts, and carefully weighing the pros and cons, you can make informed decisions that help you achieve your investment goals in real estate. Ultimately, preferred equity can be a powerful tool for building wealth and diversifying your investment portfolio, but it is important to approach it with caution and diligence to ensure success.