Preferred equity is a type of investment in which the investor receives certain privileges in exchange for their investment. These privileges can include priority return of capital or a higher rate of return than common equity investors. In the event of a sale or liquidation, preferred equity holders also generally have priority over common equity holders.
In this article, we’ll explain what preferred equity in real estate is, how it works, and some of the advantages and disadvantages to consider before investing.
What is Preferred Equity in Real Estate?
Institutional grade commercial real estate assets can be very expensive. It often requires cobbling together an assemblage of capital from various sources to purchase property, but there is another type that might work for you — preferred equity.
With this type of investment, the equity investor receives special privileges (or preferences) in exchange for their investment. The return on investment (ROI) is often higher than traditional equity, and the risks are commensurately higher as well.
How Does Preferred Equity Work?
If you’ve ever purchased a home or property, you’re likely familiar with the terms “equity” and “down payment.” Home equity is simply the portion of your home that you own outright — it’s what’s left after subtracting any outstanding mortgage balance from the property’s appraised value. Your down payment is the portion of the purchase price that you pay upfront, out of pocket.
In commercial real estate, an equity investment is generally any amount paid to the property owner in exchange for an ownership stake. The two most common types of equity investment are common equity and preferred equity. As we mentioned above, preferred equity gives the investor certain privileges or preferences over other types of investors.
There are a few key ways that preferred equity can be structured, but one of the most common is through a mezzanine loan. A mezzanine loan is a type of financing that is subordinate to a senior loan (usually a first mortgage). In other words, in the event of foreclosure, the mezzanine lender would be paid after the senior lender — but before equity holders.
Pros and Cons of Investing in Preferred Equity
Like any type of investment, there are both advantages and disadvantages to consider before investing in preferred equity. Some of the key pros and cons to keep in mind include:
Pros
- Generally higher ROI than common equity investments
- May offer some downside protection in the event of a sale or liquidation
- Gives the investor priority over common equity holders in the event of a liquidation
Cons
- Higher risk than common equity investments
- May have less control over the property than other types of investors
- Less liquidity than common equity investments
Preferred Equity vs. Common Equity: Key Differences You Should Know
Now that we’ve explained what preferred equity is and how it works, let’s take a closer look at the key differences between preferred equity and common equity.
1. Risk level
The first and perhaps most important difference to understand is the risk level. Preferred equity is generally considered to be a higher-risk investment than common equity. This is because preferred equity holders have less control over the property and may not be able to recoup their investment if the property is sold or liquidated.
2. Return on investment (ROI)
Preferred equity typically offers a higher ROI than common equity. This is because preferred equity holders receive special privileges or preferences, such as priority return of capital or a higher rate of return.
3. Control
Investors in preferred equity typically have less control over the property than investors in common equity. This is because mezzanine lenders (the most common type of preferred equity holder) are typically subordinated to other lenders, such as the senior lender or the property’s owner.
4. Liquidity
Preferred equity investments offer less liquidity than common equity investments. This means that it can be harder to sell your stake in the property if you need to liquidate your investment.
5. Priority in the event of a sale or liquidation
In the event of a sale or liquidation, preferred equity holders have priority over common equity holders. This means that they are more likely to recoup their investment before any other type of investor.
Frequently Asked Questions (FAQs) About Preferred Equity in Real Estate
Are preferred equity investments safe?
Preferred equity investments are generally considered to be higher risk than common equity investments. This is because preferred equity holders have less control over the property and may not be able to recoup their investment if the property is sold or liquidated.
What are the requirements of investing in preferred equity?
Each preferred equity investment will have its own specific requirements, but in general, you’ll need to be accredited and have a high net worth. Accreditation means that you meet certain financial thresholds, such as having an annual income of $200,000 (or $300,000 for joint filers) or a net worth of $1 million (excluding your primary residence).
What is the minimum investment for preferred equity?
There is no set minimum investment for preferred equity, but most investments require a minimum investment of at least $100,000 or more to get started.
Need Capital for Your Business? AVANA Capital Can Help
Preferred equity is a type of investment that offers a higher ROI than common equity but also comes with more risk. When it comes to commercial real estate lending, be sure to consult with a financial advisor to see which products best suit you.
Contact AVANA Capital today for your business financing needs. Whether you are looking for guidance on a real estate project or need financing for your venture, our team at AVANA Capital is here to help. We offer a variety of financing products, including direct commercial real estate loans, construction loans, and commercial bridge loans — and we’re always happy to answer any questions you may have.
We offer fast, flexible, and reliable direct lending that you can trust. Give us a call today or request a loan.
This article was originally published on avanacapital.com by AVANA Capital. Read the original post here. Accessed on May 3, 2022.
