In the dynamic landscape of commercial real estate investing, the pursuit of stable returns often encounters challenges, particularly in times of economic uncertainty and fluctuating interest rates. As interest rates have risen, underwriting models have been stretched and the fundamentals of real estate investing have deteriorated for many transactions, prompting investors to seek alternative strategies to maintain profitability and mitigate risks. In this context, preferred equity investments in commercial real estate projects emerge as a compelling option, offering a blend of security, flexibility, and attractive returns. Let’s delve into why preferred equity investments make sense in today’s high-interest-rate environment.

Understanding Preferred Equity Investments

Preferred equity investments represent a form of financing in which investors provide capital to a real estate project in exchange for preferred status in the distribution of profits and protection against downside risk. Preferred equity slots into the capital stack in-between debt and common equity. Preferred equity holders typically have priority over common equity holders in receiving distributions from cash flows or asset sales while still retaining many of the upside potential features that make common equity investments attractive. Additionally, in the event of default or liquidation, preferred equity holders are entitled to recover their investment before common equity holders, providing a layer of risk insulation.

Preferred equity terms will commonly have the following features: 

  • A principal investment: the initial dollars invested which receive payback preference to common equity.
  • A preferred return: effectively an interest rate which typically will also receive payment preference.
  • A participation in cash flow: after receiving the principal and preferred return there can be additional participation in additional returns above that level.
  • A conversion option: if the project preforms successfully the principal investment may be converted to common equity and receive the upside potential. Dependent on terms this can be before or after the payment of a preferred return.
  • A redemption right: effectively a fixed term of the investment where afterwards the investor may require a liquidity event that can pay out their investment.
  • Protective provisions and control rights: typically including approval rights for major decisions or default protections in the event of underperformance.
  • Prepayment provisions: effectively setting a minimum return floor.

The Appeal Amid High-Interest Rates

  1. Increased Demand: Banks have tightened their belts, requiring lower LTVs in order to maintain secure DSCR thresholds. This leaves real estate investors in a tight spot both in new and existing projects. As existing projects meet refinancing hurdles, banks are looking for significant principal paydowns, and new project sponsors are challenged with the need to raise twice the equity they had to for the same project two years ago, opening the door of opportunity for preferred equity.

2. Enhanced Yield Potential: What debt you can get, is expensive. As regional banks and agencies have retracted from the market, debt funds and other more expensive debt sources reign supreme, asking for eight to ten percent interest on stabilized real estate projects. Essentially preferred equity is competing directly with debt options, either in the form of mezzanine or upsized loans which ask for even higher interest rates, driving the willingness to pay for high preferred returns up. It is not uncommon to see preferred returns in the teens in today’s market.

3. Reduced Leverage Risk: Banks pulling down their LTV’s has allowed preferred equity to enter the capital stack at a lower level with more leverage insulation. Opportunities exist currently where including the preferred equity investment as debt the project is still under 70% LTV, providing a sizeable downside protection to investors.

4. Flexibility: Everyone recognizes that real estate is in a funky moment caught in between cycles and suppressed by recent banking scares. Within this environment opportunities exist but conventional financing has retreated to funding only opportunities that exactly fit in their box. Preferred equity can fill in the gap with creative terms which greatly benefit the deal sponsors if they achieve their vision but protect the preferred equity if the market doesn’t follow their planned trajectory.

While preferred equity investments present compelling opportunities in today’s economic climate, they are more complicated than conventional debt or equity investments. Having an experienced and qualified team that understands the nuances of the legal structure and how to craft the right balance between downside protection and upside opportunity are essential.

Adam Long

Adam Long

Senior Investment Advisor

Adam Long is a Special Advisor to Axia Partners and member of our Investment Committee. Adam was the Chief Operating Officer for the Intermountain region and Director of Special Projects nationally for Colliers International where he oversaw more than $4bn in annual real estate transactions. Adam was an Arjay Miller Scholar, graduating from Stanford University with an MBA and is currently a Juris Doctorate candidate at Harvard Law School.