Investing Education

Why Preferred Equity is a Good Commercial Real Estate Investment


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.

How? 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.

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.

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?

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.

This article is intended for informational and educational purposes only and is not intended to provide, and should not be relied on, for investment, tax, legal or accounting advice. The information is provided as of the date indicated and is subject to change without notice. Origin Investments does not have any obligation to update the information contained herein. Certain information presented or relied upon in this article may come from third-party sources. We do not guarantee the accuracy or completeness of the information and may receive incorrect information from third-party providers.