Preferred Equity vs. Common Equity
Preferred and common equity provide borrowers with more access to equity capital when investing in commercial real estate. Property developers or sponsors, joint venture partners, or limited partners usually invest their capital and provide common equity. They are also typically responsible for finding, acquiring, and managing the property.
Situated at the upper part of the real estate capital stack, preferred equity and common equity form its equity part. The real estate capital stack is one of the most valuable tools for investors as it helps them understand the types of funding used for financing real estate projects. It delineates the different layers in hierarchical order and allows investors to gauge the related risk and projected return rate. The lower layers have higher priority, less risk, and lower returns, and vice versa: the higher the layer, the lower the priority, the bigger the risk, and the higher the return.
Senior debt is at the bottom of the capital stack, followed by the mezzanine debt. The two types of debt take priority over its equity part, which means their lenders will get fully paid before equity investors receive any returns on their investments. After the mezzanine debt is the preferred equity, and on top of it and the whole stack is the common equity. Preferred equity resembles mezzanine debt in that it presents lenders with the possibility of a higher return and provides borrowers with extra capital in addition to the senior loan. Common equity investors will get paid last, but they have the highest return potential.
Preferred equity and common equity positions in the real estate capital stack endow them with certain advantages and disadvantages. The main benefits of preferred equity include safer returns with a steady rate, investors’ yield, and ownership interests. Preferred equity investors receive cash flow before their common equity counterparts. In addition, their accounting rate of return (ARR) or the percentage rate of the annual return on an asset or investment compared to their initial cost is steadier.
Preferred equity investors also receive a percentage from the annual revenue generated by the property. Furthermore, they have ownership interests in it, which sometimes translates into them being able to take advantage of the tax benefits related to the investment.
On the downside, preferred equity investments are not secured, and investors can lose capital. Ownership rates are not secured, which may deprive investors of recoursing to the property if the borrower does not meet their loan payments. Preferred equity has a higher priority than common equity, but it is still subordinate to the debt part of the capital stack. If a property fails to generate a high enough return, investors may lose their investment. Preferred equity investors usually do not receive upside: they do not gain if the property increases its value.
As for common equity advantages, besides receiving the highest return, typically, common equity investors have no cap on their potential returns. They also receive upside and benefit from potential property value increases and tax deductions. Common equity serves long-term investors well as it offers them the prospect of growth and profits in the long run.
In terms of disadvantages, not only do common equity investors last receive a return on their investments, but also they are the last to receive foreclosure rights if a foreclosure occurs. Similar to preferred equity, common equity is not secured. And the fact is, its investors can incur the highest losses.
