Many established real estate sponsors use preferred equity financing to build their portfolios or fill gaps in their capital stack. Preferred equity is a class of ownership in a company that owns assets such as commercial property. Investors hold this ownership in the company, not the property itself. The cash flows of a preferred equity investment often resemble a loan in second position, behind a traditional first-position mortgage. But, there are some key nuances. Unlike a secured loan, preferred equity does not usually record any liens on the entity or the property.
Risk/Reward Profile of Preferred Equity
A stake in preferred equity has significantly less economic risk than an investment in common stock. The preferred stockholders are repaid their principal before the common stockholders (“limited partners,” “general partners,” or “sponsors”) receive any cash flows generated by the entity. While the common equity accepts first-loss risk, preferred equity investors are repaid with priority distributions. Similar to bond holders, the gains of preferred equity are capped at an agreed upon rate of return, like an interest rate. However, while common stockholders are paid last, they have unlimited upside.
In any case, preferred equity is typically able to be “called” or “redeemed” like a bond at the discretion of the sponsor. This requires the preferred equity investor to accept a sale of their preferred equity units if the unpaid balance is repaid. Nonetheless, there may be prepayment penalties, minimum interest, or a minimum multiple that must be paid if the redemption is exercised early.
“Hard” and “Soft” Preferred Equity
In the event of a default by the manager of the entity, remedies to the preferred equity are structured in two general ways; “hard” or “soft.” For hard preferred equity, if certain covenants are not met, such as a missed payment, it sets off a trigger that allows the preferred equity holders to exercise control rights and takeover the company. This structure can sometimes interfere with the senior lender’s covenants and requirements, as they must approve the preferred equity investor’s ability to take over – otherwise, this is a default of the senior loan.
For a soft preferred equity holder, there are remedies for nonpayment or a breach of covenants, but they are less severe. This is because the preferred investor may not take over the entity in the event of default. For example, late payments may start accruing interest at higher default rate. And since the preferred holders’ unpaid balances must be repaid with priority over the common, this essentially dilutes the sponsors’ equity. This can be a significant motivator for the common equity to repay the preferred equity as quickly as possible. A “soft” structure is generally most applicable for certain types of senior lenders with more stringent intercreditor requirements, such as agency first mortgage loans.
Participating Preferred Equity
Often, investors like the idea of being repaid before common equity, but still want to participate in the success of a project in the event that the sponsors meet their pro forma projections. This is referred to as a participating preferred equity investment. The participation in the upside may be enabled by a relatively small share of the net profits, in addition to a fixed rate of return. Alternatively, there may be a convertible aspect to the structure whereby the investor can convert some of the unpaid balance into equity at a lower valuation.
Regardless of whether the kicker is exercised, the preferred equity holders still have the downside protection of being repaid before the common.
Taxation of the preferred equity capital, from either the sponsor or investor standpoint, depends on a number of factors. The tax treatment of the capital is usually determined by the operating agreement which stipulates whether the capital is treated as debt or equity.
If not structured properly, a sponsor receiving the capital may have major tax implications for the recapitalization (or refinance) of an owned asset, as it may be considered a sale and trigger a capital gain. Similarly, the way that the coupon payments are taxed – as either interest or distributions – must be determined by the parties.
As preferred equity is usually treated as debt, investors do not typically participate in the tax benefits from a property, such as depreciation write-offs. However, such items are negotiable. Both the investor and sponsor should consult with their tax accountant to negotiate the right terms for tax treatment.
Institutional preferred equity capital sources often fall under two categories: a senior debt lender who opportunistically provides subordinate debt; or a joint-venture equity fund who is willing to structure as preferred equity. In either case, their underwriting reflects the higher level of scrutiny that is made for an equity investment. While preferred equity is usually a debt-like instrument, investors need to account for greater risk, as their capital is placed at risk behind the senior lender. Additionally, the investor’s decision rights are usually limited and so they must place a high degree of trust in the manager’s capabilities to execute the plan. This unique dynamic creates more risk variables for the investor to consider, and price their cost of capital accordingly.
To find out if preferred equity is the right solution to fund your commercial real estate acquisition, development or recapitalization, feel free to schedule a call with us to discuss.