With so many real estate opportunities, knowing your investment’s privileges is an important aspect of your return and the potential risks involved. Preferred stock or equity and common equity real estate opportunities illustrate the range of benefits and drawbacks of different types of investments.
Explore preferred and common equity in investment properties and which best suits your financial situation.
What Is Equity in Real Estate?
Equity is a crucial part of ownership in real estate investing. Homeowners may be familiar with the concept of equity: equity refers to the percentage of ownership holders have on a given real estate asset.
Homeownership provides a straightforward example of how equity works in a real estate context.
Because real estate is a premium asset, outright ownership can be challenging to manage for individual investors. In a home ownership context, most folks will take out loans, or mortgages, on their home to get the capital required to acquire it.
The initial down payment made by the homeowners establishes their baseline level of equity in the property; that is, the homeowners’ money put down on the home, whereas the rest of the equity technically belongs to the lender.
Paying off a home mortgage’s interest rates to the issuer is a matter of acquiring more equity in the home from the lender.
Equity in an Investment Property
Equity can function similarly to homeownership for investment properties. Multiple investors may pool together funds to acquire a real estate asset, and each will have varying degrees of equity in the property based on their level of investment.
However, many real estate investment programs may structure equity differently than homeownership: the primary difference between equity in a homeownership and investment properties is the role of LLCs.
Investment properties are typically more expensive than residential real estate sold to prospective homeowners; for instance, many real estate investment strategies focus on commercial properties, which are far more expensive than residential properties.
To pool the capital required to access quality commercial properties, investors may form limited liability companies to facilitate asset acquisition.
Forming LLCs is crucial in high-value real estate investing because they have a more significant opportunity for effective investment. LLCs may stand a better chance of getting high-value loans from lenders than high-net-worth individuals.
Furthermore, LLCs present a coherent, hierarchical structure in which new investors can participate. This investor structure is called a capital stack.
What Is the Capital Stack in Real Estate?
Capital stack refers to the cumulative financial structure real estate investment programs may use to get funding. Capital stacks generally consist of four levels of investor involvement, each ranging in their level of involvement, equity held, risk, and return from the held assets. The four investor levels in a capital stack from least risky to most risky are:
- Senior debt
- Mezzanine debt
- Preferred equity
- Common equity
Senior debt and mezzanine debt typically amount to the majority of total capitalization for a given real estate investment project. Senior debt refers to capital lent from traditional, institutional investors like banks; senior debt will generally account for the mortgage on a commercial real estate (CRE) investment project.
Mezzanine debt is a bridge between debt and equity investors, providing a CRE project with more comprehensive financing options beyond senior debt.
A low return characterizes the debt portion of a capital stack. However, because debt accounts for an equity majority of a CRE project, senior debt and mezzanine are a lower risk as they are first in line for entitlement to company assets. Should company issues worsen and an LLC valuation declines to the point of liquidation, debt bondholders are the first to collect.
Higher returns and higher risk characterize the equity portion of the capital stack. A CRE project may turn to equity investors to raise the remaining capital required for property acquisition.
As the last ones, equity investors are encouraged to participate in the investment with higher return rates than debt holders.
However, equity holders face the most significant risk if a property fails or is sold at a loss; as the majority equity holders, senior debt and mezzanine debt are first in line to extract value from distributions.
Preferred and common equity have individual benefits and drawbacks that investors should be familiar with before getting involved.
What Is Preferred Equity?
Preferred equity is a fairly general term that refers to privileged equity holders in a real estate investment program. These preferred stockholders are distinct from common stockholders; they have a different number of shares and often have voting rights due to their ownership interests, which holders of common stock do not have.
The scope of their privileged status depends on the investment program and their level of involvement.
There can be “hard” preferred equity options, which are closer to mezzanine debt in the capital stack, and “soft” preferred equity options which are more similar to common equity holdings.
Preferred equity investments are similar to mezzanine ones in that they fill in funding gaps by offering privileged status to encourage more significant levels of investment. By reducing risk with privileged payment status, preferred equity shareholders can feel confident about investing more money to get a better return.
The most definitive factor of preferred equity holders may be their preferred payment status ahead of common shareholders. If an investment turns out poorly, this privileged payment status can make a huge difference in whether preferred equity investors can recoup their investment.
In short, preferred equity holders gain privileged payment status in exchange for a less favorable payout.
In some cases, preferred equity investors are the board of directors for companies whose stocks are traded on the stock market.
What Is Common Equity
Common equity investors get the best possible return in a capital stack but face the most significant risk. Common stock or equity is the top tranche in a capital stack. It typically nets a decent amount of capital for a CRE project, serving a crucial purpose in acquiring funds and rounding out the total capitalization for the project.
Because they are last in line, common equity holders face the most significant level of risk if the investment performs poorly. For one, they are unlikely to recoup any of their investment; after paying out senior debt, mezzanine debt, and preferred equity holders, common equity holders may very well get little to nothing back in common stock dividends.
Additionally, tranches lower in the stack are entitled to dividend payments before common equity holders; if an asset cannot produce a strong enough return to pay out the tranche before them, common equity holders may not see theirs.
However, investment property has a substantial rate of return and high cash flow; common equity holders stand to make a significant profit through their distributions. Lower tranche returns are capped at a fixed dividend. Alternatively, common equity holders receive the highest percentage return in the capital stack when a property produces an exceptional return.
What Is the Difference Between Preferred Equity and Common Equity?
The most apparent difference between preferred and common equity is where they stand in a capital stack and the ramifications of their position.
Preferred shareholders are in a safer position. Preferred equity holders stand a decent chance of having a portion of their investment reimbursed should an investment property fall apart.
Common equity holders do not have that privileged risk protection. Instead, common equity holders are in the most profitable position in exchange for the high level of risk.
The Importance of Knowing the Difference Between Preferred and Common Equity
The pros and cons between preferred and common equity mean one may suit your financial program more than the other.
Knowing the strengths and weaknesses of equity options in investment properties helps you make financial decisions aligned with your investment strategy, whether you like high-risk, high-reward opportunities or safer investments.