Commercial Real Estate (CRE) Investor Question #86: What is preferred equity and should I invest in preferred equity?
We’ve seen the CRE capital stack in a previous post and how preferred equity is a part of it. We’ve seen that preferred equity is a debt/equity hybrid that resides in the third position of the capital stack. It is more senior than common equity but less senior than all forms of debt (Senior and Mezzanine).
It is important to understand the risk and characteristics of preferred equity compared to the rest of the stack. PropertyMetrics explains preferred equity in detail and compares it to the rest of the capital stack.
Risk level, repayment prioritization, and return expectations:
| Risk Level: | Medium – High |
| Repayment Prioritization: | 3rd |
| Return Expectations: | 8% – 10% + “Kicker” |
Characteristics of Preferred Equity
Further explanation of preferred equity can be found in the same article. We highly recommend going through the entire article and getting familiar with the capital stack and preferred equity in particular.
Preferred equity serves a similar function to mezzanine debt in that it is meant to fill the gap between senior debt and common equity
In return for the risk associated with making a preferred equity investment, the investor is compensated with a steady return in the form of annual payments (like debt) as well as an opportunity to participate in the upside of the project should it meet certain performance goals (like equity).
The performance goals are clearly outlined in the investment contract and typically establish a threshold, above which an equity “kicker” allows the preferred equity holder to participate in additional profits.
Source: https://propertymetrics.com/blog/capital-stack/