If you are a real estate sponsor or operating partner (“Real Estate Sponsor”) seeking to raise equity for deals in your pipeline, there is a good chance you received the following feedback from some or most of your Real Estate Joint Venture equity prospects (“Joint Venture Equity Investors”):
“We don’t think that we are a good fit to provide Real Estate Joint Venture equity for this deal, but will consider providing preferred equity. Are you open to it?”
You breathe a sigh of relief, finally an interest from an equity investor. Hold your horses, however, Preferred Equity and Joint Venture Equity are not the same thing. In this blog, we will explore the key differences between Preferred Equity and Joint Venture Equity, and the considerations a Real Estate Sponsor should take into account when accepting either type of investment.
Real Estate Joint Venture Equity:
A Real Estate Joint Venture Equity investment typically refers to an equity investment made by a capital partner, in which the capital partner provides the bulk of the equity capital that the project requires. In a typical Real Estate Joint Venture, the capital partner provides up to 90% of the total equity required to fund the deal. The remaining capital is obtained through debt financing from a bank or other lender. In most cases, the capital is typically structured as common equity, and, as a result, all parties, including the operating partner and the capital partner share the risk of poor performance.
Real Estate Preferred Equity:
A Real Estate Preferred Equity investment refers to an equity investment made by a capital partner, in which the equity provided is senior to the Joint Venture Equity, or common equity, and junior to the debt component in the deal. The term “equity” represents an ownership in the property, and it is considered “preferred” because the Preferred Equity investors are paid back an agreed upon “preferred return” of cash flow after senior debt, and before the Joint Venture Equity Investor has been repaid. A major difference between Real Estate Joint Venture Equity and Real Estate Preferred Equity lies in the different levels of risks assumed by the capital partner and the sponsor. The Preferred Equity is riskier than senior debt or a mezzanine loan but less risky than Joint Venture Equity because the capital partner is not in a first loss position.
A typical Real Estate Preferred Equity Investment includes a fixed rate of return from net cash flow, as well as an accrual rate when a sale or refinance take place, typically referred to as a “capital event.” Most commonly, Preferred Equity Investors require a 9-15% return on their investment. Preferred Equity Investors are not as concerned with the real estate project’s unlimited upside, because their return is generally predetermined and capped.
Now, let’s explore the main differences between both structures:
Priority in the Capital Stack: Debt, Preferred Equity, and Joint Venture Equity are all part of what is known as the Real Estate distribution waterfall or Real Estate capital stack (“Capital Stack” or “Distribution Waterfall”). The Capital Stack is the hierarchy that determines distribution priority to all parties in a real estate transaction, and determines who is paid first upon a cash distribution or a sale of the property. In a typical Capital Stack, the debt investor (e.g. the mortgage) is paid first, followed by the Preferred Equity investor, who is junior to the senior mortgage but senior to the Joint Venture Equity Investor, followed last, by the Joint Venture Equity investor.
Risk / Reward Profile: If the Joint Venture Equity investor is paid last, why would one want to be a Real Estate Joint Venture Equity Investor? The reason stems from the fact that the risk / reward profile flows opposite to that of the Distribution Waterfall. If the project generates attractive returns, the Joint Venture Equity Investor receives the most return on its investment because it has the highest exposure to risk. Preferred Equity Investors, however, typically see a lower, fixed return, that does not increase if the project performs well. Therefore, while Preferred Equity Investors have lower risk, they also have limits on the potential upside that they can receive on their investment.
Rights and Control: Both Real Estate Joint Venture Equity Investors and Preferred Equity Investors are passive investors in the venture, entrusting the sponsor or the operating partner with the responsibility of handling the day-to-day management of the real estate property. That said, most Joint Venture Equity Investors negotiate certain major decision or control rights. Such control rights may include, but are not limited to, the following: approval of any major changes to the business plan, approval of annual budgets, ability to remove or replace the property manager or the operating partner itself in certain circumstances, and ability to trigger or veto the sale or refinance of the property. Preferred Equity Investors, however, are limited in the control rights that they may retain over the venture, since they are already somewhat protected by their higher priority in the Distribution Waterfall. Of course, many Preferred Equity Investors do negotiate some major decision rights, but those are far more limited in scope compared to the rights that a Joint Venture Equity Investor may retain.
Equity Investment Size: As mentioned, Real Estate Joint Venture Equity Investors generally provide up to 90% of the total equity required to fund the deal, with the Real Estate Sponsor being required to provide the remaining 10% of the equity in the form of GP contribution. The rest of the capital is funded through debt. Real Estate Preferred Equity Investors generally provide up to 85% of what is called loan-to-value, which is the amount a lender is willing to invest compared to the value of the property. Preferred Equity Investors may include budgeted renovation costs into the value, or determine it using a loan-to-cost calculation, which can further increase leverage. Since the Preferred Equity Investor is more concerned with limiting risk, they typically require a 40-50% layer of common equity, or Real Estate Joint Venture Equity, to be included in the Capital Stack that would be junior to the Preferred Equity Investor. Hence, the amount that can be raised by a sponsor through Preferred Equity is limited to 50-60% of the total equity required to fund the deal, while the amount that can be raised from a Joint Venture Equity Investor can reach up to 90-95% of the total equity required to fund the deal. This can be significant as the project increases in size. For example, if the Project requires a $10 million equity investment, then the amount that can be raised through a Preferred Equity Investor will generally be limited to $5-6 million, leaving the real estate sponsor with a $4-5 million equity gap. In this market environment of rising interest rates, most Real Estate Joint Venture Equity Investors will not invest in a deal that includes a Preferred Equity Investment, leading the Real Estate Sponsors scrambling to find equity through syndication in order to fund the remaining required equity.
Final Thoughts:
Both Real Estate Joint Venture Equity and Preferred Equity investments are forms of equity investments that can be utilized to fund real estate projects. In a booming economic environment, it may make sense for a Real Estate Sponsor to accept a Preferred Equity Investment as it is naturally capped in its upside participation. Hence, both the Real Estate sponsor and the Joint Venture Equity Investor can benefit from an outsized return on their equity investment since the Preferred Equity Investor’s return is capped. In an economic downturn, however, the risk to the Real Estate Sponsor is much higher because the Preferred Equity Investor is senior to the common equity as well as the sponsor’s GP equity commitment in the deal. As a result, while the deal inherently holds higher risk in a period of an economic downturn, the Real Estate Sponsor and Preferred Equity Investor assume different level of risks.
Another key consideration is the size of the investment. As discussed, Preferred Equity Investors fund only a portion of the equity in the deal, typically up to 50-60% of the equity. In a period of an economic downturn, in which equity is scarce, the Real Estate Sponsor may find itself unable to raise the remaining capital from a common equity investor, and is subsequently, unable to close on the deal. Furthermore, in a period of an economic downturn, Real Estate Joint Venture Equity Investors are averse to investing behind Preferred Equity, so, by accepting a Preferred Equity Investment, Real Estate Sponsors may actually harm their potential to raise Joint Venture Equity.
Lastly, if the Real Estate Sponsor wishes to maintain more control over the deal, Preferred Equity may offer a solution. While such investors do not share proportionally in the risk of the deal, they generally do not have a significant decision-making power.
When considering whether to accept Real Estate Joint Venture Equity or Preferred Equity to fund a real estate deal, it is important for Real Estate Sponsors to understand that each have their own pros and cons. It is also important to note that they are not mutually exclusive, and, if it makes sense in a particular deal, Real Estate Sponsors can certainly use both Preferred Equity and Joint Venture Equity. Albeit, in times of economic downturn, it may be difficult to attract a Joint Venture Equity Investor that will agree to invest in a Capital Stack that includes Preferred Equity.
Important Disclaimer: Enterstate Capital, Ltd. (“Enterstate”) published this article to convey general information about our services and not for the purpose of providing any investment, legal or tax advice. Strategies mentioned herein may not be appropriate for you. Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain. You should consult an investment professional regarding your own situation. Nothing in this article should be considered an offer of securities or the solicitation of an offer to acquire securities of any type.