Preferred equity is a type of financing becoming increasingly popular in the real estate industry. But what is preferred equity? And why should you care? Below is everything you need to know about preferred equity, plus how it’s used in the real estate market and some of the benefits that come with using preferred equity financing. If you’re thinking about investing in real estate or are just curious about what preferred equity is, then read on.
What is Preferred Equity?
Preferred equity is a financing option that is somewhere between debt and equity. Like debt, preferred equity is a loan that must be repaid, with interest. But like equity, preferred equity gives the lender a stake in the property or company they are lending to, making preferred equity a more secure investment opportunity for the lender than traditional loans, which is why it has become so popular in recent years.
How Preferred Equity Is Used In Real Estate
In the world of real estate investing, preferred equity is often a way to bridge the gap between what a developer needs to get started on a project and what they can afford. For example, let’s say you have an idea for a new building, but you don’t have the money to build it. You could go to a bank and take out a loan, but that would be risky for the bank. They would be giving you money, with no guarantee that you will be able to pay them back. Alternatively, you could find an investor willing to increase your cash flow in exchange for a piece of the project. This is what is known as preferred equity financing.
Property owners can also use referred equity for cash to make repairs or renovations. Rather than taking out a loan, which would put them further into debt, they can offer up a portion of their property as preferred equity to someone else. This gives the owner some breathing room while still allowing them to maintain control of their property.
The Benefits of Preferred Equity
Many benefits come with using preferred equity financing. Chief among them is the security it provides to both the lender and the borrower. There is less risk for both parties than with traditional loans. It’s a popular choice for real estate investors who often need a more secure investment option.
Preferred equity also comes with some tax advantages. For example, if you take out a loan to buy property, you will have to pay interest on that loan. But if you get preferred equity financing instead, the interest payments may be tax-deductible.
In addition, preferred equity typically has lower interest rates than debt, which means that the borrower will have less of a burden to bear in terms of making monthly payments.
Why Do Lenders Like Preferred Equity?
So why do lenders like preferred equity so much? There are a few reasons. First, as we mentioned earlier, it is a more secure investment than traditional loans because the lender has a stake in the property or company they are lending to, which means they are less likely to lose their money if things go wrong.
Second, preferred equity typically comes with lower interest rates than debt financing, making it a more affordable option for borrowers. It also allows them to keep more profits once they sell the property.
Finally, preferred equity often doesn’t have any prepayment penalties attached to it. The borrower can pay off the loan early without paying any extra fees.
When Is the Right Time to Finance a Project with Preferred Equity?
Preferred equity can be a great way to finance your project. However, you must have a solid plan in place before you start soliciting preferred equity investors. You need to know how much money you will need and when you need the funds. If your plan calls for raising $500,000 but only needs $100,000 now, preferred equity might not make sense. Preferred investors typically want their investment back within 36 months of financing the deal (which means they won’t return any excess capital).
Additionally, preferred equity can help bridge gaps in funding which may occur after initial construction loans expire or if there are delays due to unforeseen circumstances such as weather damage during construction, etc. It also comes with some tax benefits that are not available when taking out a loan.
Preferred Equity and Its Origins
The preferred equity financing structure has its origins in the commercial real estate market, where it was an alternative to debt financing.
In a preferred equity structure, investors provide funds that are then invested in property or other assets. In exchange for their investment, preferred investors receive preferred shares of ownership, which give them priority over common stockholders when it comes to receiving dividends and distributions from the company’s profits. The preferred investor does not have any voting rights on corporate matters unless certain conditions are met (such as if there is no board meeting scheduled within six months).
In some cases, preferred stock may be convertible into common stock at predetermined prices; however, this feature is rare because most companies want to retain control over their destiny without giving up ownership rights to preferred equity investors.
How Does Preferred Equity Differ from Debt?
Preferred equity is similar to debt in that it has a fixed interest rate and repayment period, but preferred investors are not personally liable for losses on the asset or project being financed by preferred stockholders like they would be if they were lending money directly (unsecured creditors).
In addition, preferred stock does not have voting rights except under special circumstances; however, these preferred shares can be converted into common stock at predetermined prices. In most cases, preferred equities are used as an alternative financing structure when there isn’t enough capital available through traditional sources such as bank loans or private placements of securities like bonds due to risk factors associated with those assets.
When Should You Use Preferred Equity?
Preferred equity can be a valuable tool for real estate developers who need to raise capital quickly and don’t have time to wait on traditional financing sources like banks.
In some cases, preferred equities may even provide better returns than other forms of debt financing because preferred investors receive priority over common shareholders when it comes to distribution payments from the asset being financed by preferred stockholders (this is known as seniority).
However, the preferred equity structure is not without risks. If something goes wrong with the project, every preferred equity holder loses their investment before any common shareholders do. This type of security should only be used in situations where there isn’t enough cash flow available through traditional financing methods such as bank loans or private placements of securities like bonds due to risk factors associated with those assets.
