Preferred equity in real estate refers to a type of investment that grants specific privileges to investors in exchange for their capital. These privileges often include a priority return on investment or a higher rate of return compared to common equity investors. Additionally, in the event of a sale or liquidation, preferred equity holders are typically given priority over common equity holders.
What is Preferred Equity in Real Estate?
Acquiring institutional grade commercial real estate assets can be a costly endeavor. Fortunately, there is an alternative option that might better suit your needs—preferred equity. With this type of investment, equity investors enjoy special privileges in return for their financial contribution. While the return on investment (ROI) is generally higher than traditional equity, the risks involved are also proportionally greater.
How Does Preferred Equity Work?
If you’ve ever bought a home or property, you’re likely familiar with the terms “equity” and “down payment.” Home equity represents the portion of your property that you outright own—the residual value after deducting any outstanding mortgage balance. On the other hand, a down payment refers to the upfront payment made out of your own pocket.
In commercial real estate, an equity investment typically involves a payment made to the property owner in exchange for a stake in ownership. Common equity and preferred equity are the two most prevalent forms of equity investment. As mentioned earlier, preferred equity grants investors certain privileges or preferences over other investor types.
Preferred equity can be structured in several ways, but one common approach is through a mezzanine loan. A mezzanine loan is a form of financing that ranks below a senior loan (often a first mortgage). In other words, in the event of foreclosure, the mezzanine lender is paid after the senior lender but before equity holders.
Pros and Cons of Investing in Preferred Equity
As with any investment, there are pros and cons to consider before venturing into preferred equity. Here are some key points to keep in mind:
- Generally offers a higher ROI compared to common equity investments
- May provide some downside protection during a sale or liquidation
- Grants priority to investors over common equity holders during a liquidation event
- Entails higher risk compared to common equity investments
- Investors may have less control over the property compared to other investor types
- Offers less liquidity than common equity investments
Preferred Equity vs. Common Equity: Key Differences You Should Know
Now that we’ve discussed the nature and workings of preferred equity, let’s delve deeper into the key distinctions between preferred equity and common equity.
1. Risk Level
Preferred equity is generally considered a higher-risk investment than common equity. This is due to preferred equity holders having less control over the property and facing potential challenges in recouping their investment in the event of a sale or liquidation.
2. Return on Investment (ROI)
Preferred equity typically yields a higher ROI than common equity. This is because preferred equity holders receive special privileges, such as a priority return of capital or a higher rate of return.
Investors in preferred equity often have less control over the property compared to common equity investors. This is because mezzanine lenders, who commonly hold preferred equity, are typically subordinate to other lenders, such as the senior lender or the property owner.
Preferred equity investments offer less liquidity compared to common equity investments. Selling your stake in the property might prove challenging if you need to liquidate your investment.
5. Priority in the Event of a Sale or Liquidation
During a sale or liquidation, preferred equity holders are prioritized over common equity holders. This means they are more likely to recover their investment before other investor types.
Frequently Asked Questions (FAQs) About Preferred Equity in Real Estate
Are preferred equity investments safe?
Preferred equity investments are generally considered to be riskier than common equity investments. This is primarily because preferred equity holders have less control over the property and may face challenges in recovering their investment if the property is sold or liquidated.
What are the requirements for investing in preferred equity?
Each preferred equity investment has specific requirements, but in general, investors need to be accredited and have a high net worth. Accreditation entails meeting specific financial criteria, such as having an annual income of at least $200,000 (or $300,000 for joint filers) or possessing a net worth of at least $1 million (excluding primary residence).
What is the minimum investment for preferred equity?
While there is no set minimum investment for preferred equity, most investments typically require a minimum initial investment of at least $100,000 or more.
Need Capital for Your Business? Garrity Traina Can Help
Preferred equity presents an investment opportunity with a higher ROI than common equity, but it also carries elevated risk. When considering commercial real estate lending, it is advisable to consult with a financial advisor to determine the most suitable products for your needs.
For your business financing requirements, contact Garrity Traina today. Whether you seek guidance on a real estate project or financing for your venture, our dedicated team is here to assist. We provide a range of financing options, including direct commercial real estate loans, construction loans, and commercial bridge loans. Trust in our fast, flexible, and reliable direct lending solutions. Reach out to us today or request a loan to fulfill your financial goals.