Preferred equity, or preferred shares, are investments in real estate that carry a higher risk than senior debt. They require an investor to create privity with the senior lender, and they must have their rights recognized in the mortgage loan documents. While there is no standard form for a recognition agreement, more of these agreements are similar to senior-mezzanine loan intercreditor agreements. A preferred equity investment has the potential to generate a higher return on investment, and the investor is entitled to profit participation upon a property sale.
Preferred equity differs from common equity in that it is structured differently. Most often, it involves a fixed rate of return, such as a fixed pay rate derived from net cash flow, or an accrual rate from a capital event. Preferred equity also involves a cap on returns. The risk-reward trade-off is that preferred equity investors want to limit the downside, while protecting the upside.
The preferred equity structure can differ from deal to deal, so it is important to do due diligence before committing to a deal. It is also important to understand the repayment terms and structures of preferred equity agreements. This way, if the deal goes bad, you can still get out of it with your money intact. In the meantime, the preferred equity investors should keep track of the operating agreement carefully.
Preferred equity is also often structured as a joint venture with a developer. The relationship is formally documented in a limited partnership agreement, limited liability company agreement, or loan agreement. The preferred equity investor will be a member of the management team of the partnership or company, and will approve all major decisions. Preferred equity investments will also be repaid through priority distributions to preferred equity holders. The payment schedule can be customized to meet the investor’s needs.