If you invest in the stock market, you’re probably familiar with the term “preferred.” Investors sometimes have the option to buy preferred shares of a company’s stock, if a company is willing to make that option available. Although these shares are generally more expensive, they’re also not as risky as common shares. But what does “preferred” mean as it pertains to real estate investing?
The goal of real estate developers is to increase their leverage — preferred equity helps them accomplish this goal. It allows them to finance a project with money that’s lower priority than their mortgage debt, but higher priority than the equity the developer has already committed to the project. Mortgage loans are typically enough to provide most of the capital needed to complete a project, but there are instances where a developer will need more funding, and this is where preferred equity comes in.
Similar to preferred shares in the stock market, preferred equity is more expensive than a mortgage loan and also not as risky as other types of investments, like common equity. Preferred equity can be impacted if the property were to decrease in value, so investors are paid higher interest rates to offset the risk.
Preferred equity real estate investors get priority on both their return of investment and return on investment. This type of equity has specific rights laid out in the developer’s contractual agreement and it doesn’t require an intercreditor agreement with the senior lender of the project. Like other debt, preferred equity usually has a fixed term, which is typically around two to three years. If there is a performance or negligence issue with the developer, this can trigger a situation where the developer must pay off the preferred equity interest with an amount that is equal to the unreturned capital and may accrue additional fees if there were interest earnings that weren’t distributed out to the investor. Additionally, preferred equity also fares better in the event of bankruptcy as well.
Investors know the old adage: the higher the risk, the higher the reward. While preferred equity isn’t as risky as common equity, it does offer investors a more secure equity position in a real estate development project. Both real estate companies and real estate investors can enjoy the advantages of preferred equity. Developers increase their potential returns by increasing their leverage, while investors can gain higher returns for taking on higher risk when financing these projects.
Investors should be aware that certain crowdfunding platforms and investors may sometimes call preferred equity “mezzanine debt.” While the terms may differ from one person to the next, everything else should remain the same.
If you’re considering becoming a preferred equity investor, be sure to educate yourself on its nuances and explore its benefits to see if it’s the best fit for you.
