What is a Preferred Equity Investment?
In a preferred equity investment, the investor is considered an equity partner and therefore benefits from a fixed rate of return.
For example, suppose that an investor partners with an individual who is interested in purchasing a property worth $1 million. Also, suppose that the investor asks for a fixed preferred equity return of 30%. As an equity partner, the investor generates 30% of the profit, or $300,000.
Although a preferred equity investment has reduced risks for an investor, they are limited to a specific profit. Additionally, the investor has no control over the property.
Hard Preferred Equity Investments
While there are a variety of forms of preferred equity investments, they generally can be categorized into two categories, "hard money" and "soft money" investments. Hard money preferred equity operates much like a loan. It usually requires the property owner to make monthly interest payments and pay the entire investment back by a certain date, regardless of the financial performance of the property itself.
If the property owner does not make the payments, the preferred equity investor can assess a penalty, and may even be able to take ownership of the property itself after a certain period of time. Getting a hard preferred equity investment may be more difficult and time-consuming, because it often requires that the preferred equity investor negotiate with the lender in order to work out the details of the deal.
Soft Preferred Equity Investments
In comparison, a soft preferred equity investment is generally much more lenient. Soft preferred equity investments typically don't require interest payments (unless the property is generating a significant profit) and often do not require full repayment at a certain date. Additionally, soft preferred equity investors usually cannot assess penalties against the property owner if they don't pay on time and can't take possession of the property if the owner fails to make payments. Since they are less likely to reduce a property's cash flow or lead to any changes in the project's management, lenders tend to prefer soft equity deals,
Preferred Equity vs. Mezzanine financing
Preferred equity is quite similar to mezzanine financing in many respects. The main difference is that preferred equity is a direct ownership stake in a property, whereas mezzanine financing is a form of debt that can be converted to equity in case the borrower defaults. In many cases, mezzanine debt investors may not be granted equity directly in the property itself, but in the entity that owns the property. Sometimes, this makes things slightly more complex from a financial standpoint.