Preferred equity investments are in a junior position behind the first mortgage but are in a senior position to the borrower’s/sponsor’s equity investment.




Here is an example of it:




When cash flow is produced from an income-produce property or profits are earned upon a capital event (sale or refinance), the preferred equity investors are paid after the senior lender, but before the borrower’s/sponsor’s equity.  Since preferred equity is junior to the senior mortgage, it carries a higher degree of risk and warrants a higher rate of return than the interest rate charged on the first mortgage.




Preferred equity can be structured in many different ways, but it usually involves a fixed rate of return that is satisfied through a “pay rate” or “current pay” from the cash flow, and an “accrual rate” that is typically paid upon a capital event (sale or refinance). 




The returns of preferred equity investors are typically capped, so the common equity can reap most, if not all, of the profits after the preferred equity investors are paid.  Conversely, preferred equity investors are willing to cap their upside by protecting their downside with a more secure position in the capital stack.




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