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What is Preferred Equity?

David Austin • Jan 24, 2020

A basic overview of preferred equity, and how it is used

Real estate investments sometimes offer a class of investment called "preferred equity." This means that the preferred equity is paid first, before everyone else, called common equity.

Like Debt and Like Equity
Preferred equity acts like both debt and like equity. Investors will periodic payments of a fixed amount, like an interest payment on a bond. They also participate - with limitations described below - in the profit made from the investment, like equity investors.

How this Works
During the course of an investment, the investment sponsor determines how much cash should be distributed and at what intervals. The first group in line to be paid is in the best spot because the chances of being paid in full from income from the property are very high. Usually, the bank holding a mortgage on the property takes first place. Then, in an investment with preferred equity, the preferred investors are paid right after the bank. This spot, right after the lender, makes them "preferred" when compared to the common investors. Whatever is left - and it could be a little or a lot - is taken by common equity holders.

Added Bonus: Cumulative
Some preferred equity interests are also cumulative , which is an added benefit. If a distribution of income is skipped for some unanticipated reason, it will be repaid to the preferred owners in the future. These interests are called " cumulative preferred. " At the end of the investment, when the investor's original contribution is returned, the investment sponsor ordinarily confirms that each investor reached their stated rate of return and, if not, provides "catch up" before anyone else is paid.

Cap on Return
One of the downsides to preferred equity is that there is a limit total return. So, a preferred equity investment that provides a minimum 10% preferred return also means that the investor's total upside in the investment is capped at 10%. In this case, if the investment's return is greater than the 10%, the preferred investor is left at 10% while the common interest holders make more. The trade for the relative safety of the preferred return is this limit.

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Cap Rates and Valuation

By David Austin • 05 Sep, 2018

When I was in graduate school at Johns Hopkins, our analysis professor, a successful commercial real estate developer in Baltimore, railed against cap rates. He believed that internal rate of return (IRR) was the only viable way to look at an asset's performance and we were told to stay away from the dreaded cap rate. However, cap rates are too prevalent in the industry to ignore, so it's important to understand what they mean and how they're calculated. A cap rate is, at its simplest, the ratio between net operating income and value of the property. It really is just a snapshot of the unleveraged rate of return on an investment for a single period in time. However, there are many variations of the cap rate. Most of the time, brokers and investors look at the "entry" cap at acquisition and the "exit" cap at sale, but you can also look at building, equity, mortgage, and land cap rates. However, cap rates are not all calculated in the same manner and do not account for certain important variables. For example, taking a cap rate from current rental income (relatively less risk) and extrapolating it to future income (more risk) may result in an artificially inflated value. Some analysts include replacement reserves and some do not. It also may not be accurate to compare the cap rate from a higher risk property (without ample reserves, solid management) with that of a lower risk property. The bottom line is when comparing cap rates, it is important to understand how the cap rate was calculated. It is good practice to consistently apply the same protocol internally when looking at cap rates to determine what adjustments may be necessary, and whether cap rates were calculated using similar methodologies.