Co-Founder and Managing Partner of Disrupt Equity. Learn more about investment opportunities by visiting our website.
In the volatility of today’s economic climate, many investors are looking for stable and consistent returns with low exposure to risk. Preferred equity is a special financing structure that provides investors the opportunity to achieve consistent returns with significantly reduced risk.
What Is Preferred Equity In Multifamily?
Preferred equity is a structure of capital financing commonly used within large commercial real estate investment opportunities. The purpose of preferred equity in multifamily real estate is to reduce the capital requirements for the deal sponsor by raising funds from preferred equity investors to make a deal sponsor’s equity raise way more manageable. Preferred equity investing is generally offered from private equity groups that work with real estate syndicators/deal sponsors that require additional funding for their projects. There are various firms an investor can work with, such as EquityMultiple, Yeildstreet and the firm I co-founded, Disrupt Equity. Similar to common equity investment opportunities, having access to these offerings requires an investor to have a relationship to the firm which can be built by networking and building relationships with others in the multifamily industry.
Preferred equity funding will sit on top of debt within the capital stack. A capital stack refers to the layers of financing capital, and each layer will come with priority positions for receiving returns. When it comes to preferred equity in multifamily, preferred equity investors will receive a priority position regarding the repayment of the profit earned or any cash flow from the property. Preferred equity investors will get paid right behind the bank and before the deal, sponsors and limited partners, also referred to as common investors, can receive any profit from the property.
Similarly, suppose there is a case where the multifamily property does not perform. In that case, preferred equity investors are also above common equity investors and owners to get their money back in full. This senior position in the capital stack reduces the risk for preferred equity investors.
How Is Preferred Equity Different From Common Equity?
A common equity investor will be purchasing the shares of the property and will earn returns based on the property’s performance. Although common equity investments are generally riskier, they also may earn a much higher return than preferred equity investors if the property performs well.
Preferred equity investors will always get paid after the bank and before common equity investors, which is why common equity investors may not always receive cash flow returns while the property is held.
Example Of Multifamily Preferred Equity
Suppose a multifamily real estate syndication firm is looking to buy a sizeable multifamily asset that costs $18 million. The syndication firm received a $12 million loan from the bank, leaving $6 million to raise to acquire the deal. This $6 million raise is too big for the syndication firm to raise from its investor pool, so the need for funding creates an opportunity for a partnership with a preferred equity fund to participate in the multifamily project. If the preferred equity fund agrees to bring $3 million, this leaves only $3 million for the syndication firm left to raise from its investors.
Pros And Cons
As with any investment vehicle, investors must weigh the pros and cons of an investment opportunity to determine if it’s suitable based upon their risk tolerance and financial goals. The advantages include consistent returns to investors within shorter time frames, less risk and, depending on the terms of the contract, preferred equity investors may have the power to seize ownership of the asset in the case of a default of payment, ultimately reducing the risk for investors. On the downside, however, if the deal performs very well, preferred equity investors may receive lower returns than common equity investors.
For investors looking for consistent returns at a reduced risk, preferred equity investing in multifamily is an option worth exploring.