How Does preferred equity work?
Terms like “prefs” or “preferred equity” are used frequently to refer to monetary arrangements with investors or lenders in real estate ventures. Here are a couple of common uses and their meaning:
“I have an investor but she wants a 12% pref. In this market that’s too rich.”
Translation - The investor wants a minimum 12% return on her money before the sponsor gets a disproportionate share of cash flow. While there are lots of variations including the now more common IRR calculation, the “pref” is often used to refer to the price the investor takes for investing the risk capital before she lets the sponsor of the project get a “promote” a/k/a “carried interest” above what his cash investment would otherwise bring. While there can be covenants and ramifications for breaching the covenants, the pref or IRR is typically only paid from available cash flow.
“Because of my low leverage, the mortgagee accepted my hard preferred equity investor.”
Translation - This type of preferred equity in real estate is more of a loan than a true equity investment. Daniel Rubock, a lawyer with Moody’s and a participant in an email list of experienced commercial real estate lawyers in New York, summarized the issue nicely in recent post to the list as follows:
“…there’s “debt-like” preferred equity and “equity-like” preferred equity. The debt-like preferred equity is similar to a mezzanine loan without the pledge. At Moody’s, we consider (and penalize with a “leverage penalty”) for debt-like preferred equity that has a hard coupon or a hard maturity with (importantly) material consequences (e.g., change in control, trigger of sale rights, other clever stuff) for the failure to meet either.”
So, the next time you have an investor say to you that she is willing to give you “preferred equity,” ask a few questions about the terms - the difference may affect your ability to obtain full leverage from a mortgagee.
Preferred equity, self-exercising structure, offers a few advantages for investors. With it, there is no need for an inter-creditor agreement signed by the senior lender. In a bankruptcy situation, investors do not need to worry about an automatic stay and can enjoy other benefits, although the senior lender remains in a primary position in these scenarios.
Investors also get accelerated repayment and a preferred return rate. They can use preferred equity to create unique and beneficial structures which allow them to enjoy some cash flow distribution. Return rates for investors are higher, although risk is as well.
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PartnerTom represents owners, operators and developers in the acquisition, financing, development, ground leasing, and sale of significant properties. His experience includes office towers, commercial condominiums, industrial ...