Preferred Equity
In the capital stack of a commercial real estate deal, every dollar has its place—from senior debt at the bottom (least risk, least return) to common equity at the top (highest risk, highest return). Preferred equity sits right in the middle—offering a unique blend of higher returns than debt, but less risk than common equity. It’s a powerful tool for sponsors and investors looking to fine-tune their capital structure without giving up full control.
What Is Preferred Equity?
Preferred equity is a capital contribution to a real estate project that ranks senior to common equity but junior to all debt in terms of repayment priority. Preferred equity holders have a contractual right to a fixed return, and they get paid before the common equity receives distributions—but after all loans are repaid.
Think of it as equity that behaves a lot like debt, often with no upside participation unless specifically negotiated.
Key Features of Preferred Equity
Position in Capital Stack:
Subordinate to senior (and mezzanine) debt
Senior to common equity
Return Profile:
Fixed preferred return (e.g., 10%–13% annually)
May include PIK (payment-in-kind) accruals if cash flow is insufficient
Term and Exit:
Typically 3–7 year horizon
Exit via refinance, sale, or recapitalization
Security and Control:
Not secured by real estate (unlike debt)
Terms are governed by operating agreement or side letter
Often includes remedies for underperformance (e.g., control rights or forced sale rights)
How Preferred Equity Works
Let’s say a developer is buying an apartment building for $20 million:
Senior Loan: $13 million (65% Loan-to-Cost)
Preferred Equity: $4 million (20%)
Common Equity: $3 million (15%)
In this setup:
The lender gets paid first (debt service, principal)
Then, preferred equity receives its contracted return (say, 10%)
Only after that does the common equity (usually the sponsor and LPs) receive profits
This allows the sponsor to raise more capital without further diluting common equity—a major advantage in competitive deals.
Why Use Preferred Equity?
For Sponsors:
Increase leverage without taking on more debt
Avoid diluting GP ownership or control
Fill gaps in the capital stack when common equity is limited
For Investors:
Higher returns than debt, with more downside protection than common equity
Priority distributions
Attractive risk-adjusted yield in stabilized or transitional deals