Quick Take: A preferred equity real estate investment occupies the middle tier of the capital stack, sitting below debt but above common equity. For accredited investors, it offers a compelling balance of risk and reward by providing consistent, downside-protected yield, often with targeted returns ranging between 8% and 15%, and priority repayment over common shareholders, without taking on the maximum risk of total ownership.
The Current State of Real Estate Investing
There is a paradox of plenty in today’s multifamily housing market: Too many investors are looking for deals. Competition is driving up prices and making it harder to earn high yields. We are finding expected returns from 12% to 13% instead of the high IRRs we’ve been used to seeing when we underwrite potential deals.
But ownership, or common equity, comes with risk. That’s why we’re turning to preferred equity. Real estate preferred equity investments can yield anywhere from 8% to 15% returns. But they offer a protected position that diminishes risk. And regular income equals or can exceed the expected profits we’re seeing from common equity today.
What is Preferred Equity in Real Estate?
When evaluating commercial real estate opportunities, one of the most common questions from beginner investors and high-net-worth individuals alike is: what is preferred equity?
In short, preferred equity is a financing instrument that bridges the gap between debt and common equity. It allows sponsors (the developers or operators) to secure the additional capital needed to fund a project without giving up too much ownership control or taking on excessively expensive debt. For the investor, a preferred equity real estate position provides a target rate of return that must be paid before the sponsor or common equity holders see any profit.
Preferred Equity vs. Preferred Stocks
How does this look in practice? Preferred equity has many similarities to preferred stocks, which income investors love for their set dividend payments that provide them with income. Though more expensive than common stock, preferred stocks pay out first—a huge advantage in uncertain markets.
The same principle applies to preferred equity in private real estate, making it an option worth considering for investors when climbing property prices and increasing construction costs cut into profits.
Where Preferred Equity Sits in the Capital Stack
To truly grasp the value of a preferred equity investment, it helps to understand exactly how the capital stack works. The capital stack is the underlying financial structure of a real estate deal, dictating the hierarchy of risk and repayment priority.
From bottom to top (lowest risk to highest risk), the capital stack generally looks like this:
- Senior Debt: This is the primary mortgage on the property. Senior debt holds the lowest risk because the lender has the first lien on the property and is the first to be repaid. However, it also offers the lowest potential return.
- Mezzanine Debt: Sitting just above senior debt, mezzanine debt is a secondary loan secured by an interest in the entity that owns the property, rather than the property itself.
- Preferred Equity: This sits below all debt but above common equity. It offers higher yields than debt instruments but comes with priority repayment rights over common shareholders.
- Common Equity: Sitting at the top of the stack, common equity holds the highest risk. Common shareholders are the last to be repaid and absorb any initial losses, but they also capture the uncapped upside if the property significantly overperforms.
How Does Preferred Equity Work?
Unlike preferred stocks, preferred equity refers to a wide class of investments. Investors at this level have a higher priority than common equity investors. Their cut of income distributions and ownership comes first. In the capital stack—the hierarchy that dictates whose interests get repaid first in a private equity real estate deal—preferred equity sits below common shareholder equity but above debt. If an asset underperforms, this position lessens investors’ risk. Preferred equity shareholders must be repaid before common shareholders. So its expected risk and potential reward is lower than common equity.
Like preferred stocks, preferred equity is usually a non-voting ownership stake, though today it’s become flexible. For instance, “hard” preferred equity is similar to mezzanine debt and offers investors some decision-making powers. “Soft” preferred equity may include financial upside if a project does well. Offering documents specify the parameters of such shares; review them before investing. Once all debts are paid, preferred equity shareholders can claim profits until they meet the targeted amount before common equity holders.
Don’t confuse a preferred equity position with a preferred return. That is a feature of the waterfall of distributions that pay shareholders ahead of managers. Preferred equity shares call for priority distributions, or payment arrangements similar to loans, in which preferred investors must be repaid whatever the project’s cash flow status.
There’s a risk-reward trade-off in becoming a silent partner with a preferred equity position, rather than taking a controlling interest. In a money-losing deal, common shareholders and their management co-investors are first to take a hit. In an overperforming asset, both classes of shareholders expect to get their principal back. But if common shareholders bear more risk, they should be entitled to a higher premium.
Why Preferred Equity Is Our Choice
In a typical preferred equity real estate deal, lenders contribute 60% of the capital stack and , and earn the right to be repaid first. The preferred equity owner holds up to 20% of the financing—and is the next in line for repayment—leaving the remaining capital in common shares. With this capital stack, if a $100 million deal loses $20 million, preferred shareholders receive full repayment of their invested equity. Common shareholders bear the entire loss.
Of course, neither common nor preferred shareholders know for sure whether the property will be an under-performer or an over-performer. Both are rooting for a win, but preferred investors are hedging their bets over the common shareholder. And in today’s financing market, this can be a good strategy.
The Risk-Reward Tradeoff in Action
For instance, at Origin we have a rigorous underwriting process designed to limit risk in choosing and structuring deals. Considering the potential for loss, we have been targeting a 13% to a 15% internal rate of return (IRR) for a controlling common equity position or full ownership. Given market fundamentals today, few properties we underwrite pencil out at that rate of return though, and those that do are worth pursuing as a principal owner. More properties fall just shy of such a profit in our projections—let’s say an IRR of 11% to 13%.
In those cases, we look instead at structuring a preferred equity deal. The lower risk of a preferred equity position would make the lower return worth considering. As it happens, though, preferred equity investments in our emerging real estate markets can command an IRR of 8% to 15%. If putting up preferred equity can produce nearly the same or even higher returns as we would expect owning and managing the property ourselves—with a more protected position—why wouldn’t we take the deal?
Why This Matters for Real Estate Investors
For high-net-worth individuals and accredited investors, constructing a resilient portfolio requires balancing growth with wealth preservation. Preferred equity serves a distinct and highly valuable role in achieving this balance.
First, it offers downside protection. Because preferred equity sits senior to common equity, the property’s value would have to drop significantly, wiping out the common equity entirely, before the preferred equity principal is impaired.
Second, it generates consistent income. Unlike common equity, where cash flows can fluctuate based on property performance and capital expenditure needs, preferred equity generally provides a fixed, contractual rate of return. This makes it an excellent tool for investors seeking steady, predictable distributions without taking on the heightened risks associated with traditional property ownership.
Preferred Shareholders Are Not Always Silent Partners
While preferred shareholders are not managing partners, their agreements often give them special rights. Chicago-based law firm Blank Rome says preferred shares usually have a mandatory repayment date. Philadelphia-based law firm White & Williams notes that preferred shareholders may be able to block major decisions of the general partners, or to foreclose or remove the developer. That’s not necessarily good, since it may place a sudden burden on the preferred investor to take over management of a troubled project. However, at Origin, we know how to own and grow real estate assets. This is not our plan when we invest in preferred equity, but it gives us optionality.
Behind the preferred investor’s risk-reward calculation are a range of broader financial goals. Many of our investment partners will gladly give up some potential upside if they can generate steady income with less risk. High-return properties such as opportunistic or value-add projects need time to fill vacancies or renovate units. A predictable passive income stream can complement a more fluid turnaround project.
But the current state of the real estate market makes it less worth holding out for a bigger share of potential profit. Tenants’ budgets are stretched. Neither salaries nor family incomes are growing fast enough to afford big rent increases. Valuations are fairly priced, with few bargains to be found. It’s not a world where a 50% annual profit is a reasonable expectation any longer. If returns are most likely to range between 8% and 20%, a protected 8% or 15% is a good outcome.
There is a private real estate investment strategy for virtually every investor.
FAQs
What is preferred equity in commercial real estate?
Preferred equity is a layer of financing in the real estate capital stack that sits below senior and mezzanine debt, but above common equity. It gives investors priority over common shareholders for receiving cash distributions and the return of their initial principal.
What is the difference between preferred equity and common equity?
The main difference lies in risk and repayment priority. Preferred equity investors are repaid before common equity investors and typically receive a fixed target return. Common equity investors assume the most risk by being paid last, but they retain the potential for uncapped upside if the property performs exceptionally well.
How does preferred equity differ from mezzanine debt?
While both sit in the middle of the capital stack, mezzanine debt is legally structured as a loan secured by a pledge of ownership interests in the property-owning entity. Preferred equity is an actual ownership stake (equity) in the entity, usually carrying rights to a fixed rate of return rather than strict loan interest.
Is preferred equity safer than common equity?
Yes. Because preferred equity sits higher in the capital stack, common equity must be entirely wiped out by asset devaluation or operating losses before preferred equity investors lose their principal.
Can preferred equity investors take over a property?
It depends on the operating agreement. “Hard” preferred equity often includes specific rights that allow the preferred investors to remove the sponsor or take control of the asset if the sponsor defaults on payments or violates major covenants.
