Preferred equity has its advantages over other shareholder classes. But along with those advantages are some disadvantages. In this article, we’ll go over what preferred equity is and how it is used in real estate.
Preferred Equity Defined
Preferred equity is a type of shareholder class. When a company files for bankruptcy, equity and debt holders are paid in a specific order that is dependent on the type of financing they are holding (also called the capital stack):
- Bondholders (debt)
- Preferred equity
- Common stock
The above might be flipped, depending on how it is described. If the company files for bankruptcy, a liquidation event is triggered. Bondholders are above everyone else and paid first (i.e., the return of capital). Then comes preferred equity shareholders and, finally, common stockholders. Common stockholders are generally left holding the bag and don’t receive anything in the event of a bankruptcy.
While some private stock may have class shares, they are more common in public stocks such as Microsoft or Oracle.
Preferred equity/stock pays a higher dividend than any dividends common stockholders might receive. Preferred equity dividends can also be paid in arrears, while common stockholders only receive the next dividend payment.
One disadvantage of preferred equity is that it does not really appreciate. Instead, preferred equity investors are looking for a fixed income and return of capital (in the event of bankruptcy). If you are looking for stock gains, common stock is the best way to go. Preferred equity behaves more like a bond than a stock. And like a bond, preferred equity is also sensitive to changes in interest rates.
Does Preferred Equity Apply In Real Estate?
In direct real estate, there are no class shares. But that doesn’t mean private deals don’t have various capital or equity classes. This goes back to the capital structure mentioned above. In a private real estate deal, private equity is part of the capital structure. These are often larger deals that involve institutional investors. These deals are also called private equity deals.
The various components of the capital structure are defined in the real estate investment entity’s contractual agreement. This entity is usually an LLC and the one that purchases real estate. The contractual agreement is called a partnership or operating agreement and is put together by a law firm.
As a side note, in real estate, preferred equity may also be called participating equity or just “pref.”
Preferred and common equity is split across limited partners (LPs) and general partners (GPs), respectively. LPs are passive investors bringing funds into a project. GPs are the people managing the project. GPs promise LPs a particular return on investment, which is why LPs get involved in the project. This return is called the preferred return. GPs must deliver the promised return to LPs. In most deals, GPs will not get paid if they cannot deliver the promised return. After all, LPs are there to make money, and if they can’t, GPs shouldn’t either.
Preferred equity is used by some sponsors to increase leverage. In addition to any debt a project may have, a sponsor can further increase the project’s leverage by raising capital through preferred equity. The process of raising capital is called real estate syndication.
Preferred equity will come with specific contractual agreements. These include where preferred equity exists in the capital stack. Like a bond, preferred equity also has a finite period that it can be held. This period and what happens at the end of it is defined in the agreement as well.
Private real estate funds are securities and can also have preferred equity. It is up to the fund if it wants to issue different share classes. Some funds may have no preferred equity, while others might have multiple share classes, including preferred equity.
Do REITs Have Preferred Equity?
Yes - most REITs are securities and offer preferred equity shares. REITs can be both public and private, but that status does affect whether they can offer preferred equity shares or not.
REITs behave just like stocks. Buying preferred equity in a REIT isn’t much different from buying preferred equity in a stock.
Do DSTs Have Preferred Equity?
A DST is a Delaware entity and a trust. It is registered as a security federally and through the state. However, there are no class shares in a DST. Investors in the DST are called beneficiaries and not shareholders—beneficiaries in the DST own beneficiary interest rather than shares.
Some preferred equity funds will invest in a DST, but these funds do not create preferred equity within the DST.
For investors looking for potential, consistent income that is lower risk than common equity, preferred equity can be a good option. One drawback of preferred equity is that it may not participate in any upside (i.e., appreciation). On the other hand, preferred equity investors are paid ahead of common equity investors if the deal fails.