Preferred Equity (series 1 of 4)

How does it play in a real estate deal?

Preferred equity is an important part of the capital stack in the CRE industry. It can be very helpful for builders and developers because it provides them the capabilities to access debt financing at a lower cost than common equity. Preferred equity can be structured in many ways, but it usually involves a fixed rate (the “preferred return”) and sometimes an upside coupon that is typically paid upon a capital event (sale or refinance of the project).

Although preferred equity is often compared (and confused) with mezzanine debt, they are different. Both are used as a form of what’s called “gap funding”. In order to secure senior financing, many developers/sponsors are required to bring additional equity, and preferred equity is the answer to help developers to fill that gap. This helps the sponsor, builders and developer to have access to the capital (debt financing) they need to develop/build a project. They both have a senior position over common equity, but junior to senior debt.

Preferred equity investments are in a junior position behind the senior debt but are in a senior position to the sponsor’s equity investment, often referred to as common equity. Here is an example of this: If the project is an income-producing property, preferred equity investors get a preferred return after mortgage, property taxes, insurance and OpEx have been paid. They will get paid before developers get paid. Preferred equity investors might also receive a coupon once the property gets sold or refinanced. At Capital Insiders, preferred equity returns are in the range of 16% to 20%.

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