Preferred Equity: A Guide to Smart Investment Returns

In today’s investment world, finding options that offer both growth and safety is more important than ever. Preferred equity stands out as a powerful choice, giving investors higher returns with added security—helping them succeed in both stable and uncertain times.

Whether you’re looking into real estate or corporate finance, understanding preferred equity can lead to smarter investment choices. This guide will walk you through its key benefits, uses, and how it’s shaping the market, helping you see if it’s right for your own financial goals.

Understanding Preferred Equity

Preferred equity is a unique financial tool that combines elements of both debt and equity, giving it the flexibility of ownership without the strict repayment rules of a loan. For companies, it’s a valuable way to raise funds without the pressure of fixed payments, making it a popular choice for flexible financing.

Preferred equity comes in several forms, each with its own advantages.

• Perpetual Preferred Stock, for example, has no maturity date, so investors need to sell their shares to exit.
• Convertible Preferred Stock offers flexibility by allowing investors to switch their preferred shares to common stock, based on a set exchange ratio.
• There’s also Hard and Soft Preferred Equity: Hard preferred equity functions like mezzanine debt, giving investors some decision-making power, while soft preferred equity may offer extra financial returns if the project does well.

Key Features and Characteristics of Preferred Equity

Preferred equity offers investors unique advantages, providing both security and flexibility. One of the main benefits is dividend priority—preferred equity holders receive their dividends before common shareholders, which can provide more stability in volatile markets. In the event of liquidation, preferred equity holders also have a higher claim on assets than common shareholders, ensuring their returns are protected.

Another appealing aspect of preferred equity is the absence of fixed payments.

Unlike debt, which requires regular interest payments, preferred equity does not impose these obligations, offering companies more financial flexibility. This makes it especially useful for businesses with unpredictable cash flows, allowing them to focus on growth without the pressure of fixed repayment schedules.

Preferred equity also strikes a balance between risk and return. It occupies a middle ground between senior debt and common equity:

• Risk-Return Profile: Offering a higher return than debt but lower risk than common equity, preferred equity provides a fixed rate of return, though it limits potential upside.
• Control and Decision-Making: Generally, preferred equity holders have less control over the company compared to common equity holders, though some structures grant limited decision-making powers.

These characteristics make preferred equity an attractive option for investors seeking reliable returns with some added protections.

Cost Structure and Returns of Preferred Equity

Preferred equity is known for providing a higher return on investment (ROI) compared to common equity. This is due to its priority in the return of capital and its elevated rate of return. Preferred equity holders receive set dividend payments, which can be either fixed or adjustable, and are often expressed as a percentage in the issuing description. 

The return structure of preferred equity is straightforward. Investors receive all cash flow or profits once all debts are repaid, until they achieve the agreed-upon preferred return. In real estate, for example, typical pricing for preferred equity in 2024 ranges from 12% to 14%, with some deals reaching higher than 14%. This attractive yield structure offers a protected position that reduces risk, with preferred equity investments yielding returns typically between 8% and 15%.

Case Example: Edgewood Capital’s Preferred Equity Program

To demonstrate the advantages of preferred equity, let’s look at Edgewood Capital’s Preferred Equity Program.

This program provides $2 million to $5 million in preferred equity for value-add acquisition and real estate development projects. It offers a preferred return of 10-12% and includes profit sharing on a 50/50 basis for excess profits after payment of preferred return and return of capital to both the senior equity and the sponsor. 

The program can cover up to 80% of the required equity in a senior position to the sponsor’s equity, with a typical closing time of 10-15 business days.

Such programs highlight the flexibility and potential returns of preferred equity investments, making it a compelling option for investors seeking both security and growth potential.

Preferred Equity in Private Markets vs Public Markets

In private markets, preferred equity stands out due to its flexibility and the ability to tailor terms to meet specific company needs. Having worked extensively in the investing field, I’ve seen that this flexibility often supports companies in the growth phase or those navigating complex financial situations.

In private real estate transactions, preferred equity typically sits below common shareholder equity but above debt in the capital stack, ensuring investors are repaid before common shareholders in case of liquidation. This hierarchy helps reduce risk, making preferred equity attractive to cautious investors.

In public markets, preferred stock trades similarly to common stock but offers unique benefits, including:

• Higher Claims: Preferred equity holders have a stronger claim on dividends and assets, providing a more secure investment.
• Risk Mitigation: In case of underperformance, preferred stockholders are paid out before common shareholders, reducing potential losses.

Though less common in public markets, preferred equity still serves an important role. Overall, it offers a balanced risk-return profile, appealing to both companies seeking flexible financing and investors seeking security with higher returns than common equity. Across both private and public markets, preferred equity plays a crucial role in capital structures, providing stability and security for companies and investors alike.

Rights and Privileges of Preferred Equity Holders

Preferred equity holders benefit from a set of distinct rights and privileges, offering advantages over common stockholders:

• Dividend Priority: Preferred stockholders receive dividends before common shareholders, creating a more stable income stream. This priority is especially appealing to investors looking for reliable returns.
• Liquidation Preference: In case of a company liquidation, preferred equity holders are paid out before common stockholders, often at a pre-negotiated liquidation value—adding security for risk-conscious investors.
• Conversion Rights: Some preferred stocks come with the option to convert shares into common stock, allowing investors to participate in the company’s growth. In my experience, this feature has been especially popular among investors who value both income stability and potential upside.
• Callability: Companies may have the right to repurchase preferred shares at a set price. This can provide liquidity to investors, although it may also pose a downside if the redemption price is below the current market value.

Beyond these key rights, preferred equity holders may also receive additional privileges:

• Voting Rights: While generally non-voting, some preferred stocks grant limited voting rights in certain conditions, such as when dividends are unpaid.
• Participating Dividends: Certain preferred stocks allow shareholders to earn additional dividends if the company meets specific financial goals.
• Cumulative Dividends: Preferred equity with cumulative dividends ensures that any missed payments are made up before future dividends go to common stockholders, providing added income security.

These features make preferred equity an attractive option for investors seeking both stability and potential growth in their portfolios.

Preferred Equity in Capital Structure

Preferred equity plays a vital role in a company’s capital structure, offering a blend of debt and equity characteristics. One of the key advantages is the priority in claims. Preferred stockholders have a higher claim on company assets and earnings than common stockholders, both in prosperous times and during financial distress.

The seniority of preferred stock means it ranks above common stock in the event of liquidation or bankruptcy. This seniority provides a level of protection for investors, making preferred equity a more secure investment option.

As a hybrid security, preferred stock combines the predictable income stream of debt with the ownership rights of equity. This unique combination makes it an attractive option for investors seeking both income and potential growth.

Companies benefit from the flexibility of issuing various types of preferred stock with different levels of seniority and dividend payouts. This flexibility allows for effective capital structure management, catering to the specific needs of both the company and its investors.

Tax Implications of Preferred Equity

Investing in preferred equity comes with its own set of tax implications. One of the primary benefits is the capital gains tax rate. Preferred stock dividends are typically taxed at this lower rate, offering tax advantages to investors.

However, the tax treatment of preferred stock can be complex. Investors must adhere to specific requirements under the Internal Revenue Code (IRC) to ensure their investment is treated as preferred stock. For instance, the non-voting requirement is crucial for federal tax purposes. Preferred stock must be non-voting to qualify under IRC § 1504(a)(4).

Risk Considerations for Preferred Equity Investors

While preferred equity offers several advantages, investors should be aware of the associated risks:

• Volatility: Preferred stock prices are generally more stable than common stock, but they can still be influenced by changes in interest rates.
• Call Risk: Companies may redeem preferred shares at a set price that could be below the market value, potentially resulting in a loss for investors.
• Conversion Risk: Converting preferred shares into common stock may lead to dilution of ownership or value, impacting the overall investment.
• Liquidity Risk: Preferred shares tend to be less liquid than common shares, which may make it challenging to sell them quickly if needed.

Despite these risks, preferred equity provides certain protective measures, such as downside protection through liquidation preferences and veto rights, helping to shield investors from major losses in adverse scenarios.

According to Annie Dickerson, Founder & Chief Brand Officer @ Goodegg Investments:

“The best way to mitigate risk, whether you’re considering preferred equity or common equity investments, is to ensure that you’re investing with sponsors and operators that you know and trust, and who have an established track record of success.”

If you’re interested in learning about a related investment option, check out our article on Growth Equity Investments.

Preferred Equity in Real Estate Investments

Preferred equity is a fascinating component of real estate financing, offering a unique position in the capital stack. It sits between debt and common equity, providing a mixture of security and potential returns.

This type of equity is subordinate to all forms of debt but takes precedence over common equity, ensuring that preferred equity holders are repaid before common equity holders in the event of liquidation. This positioning makes it an attractive option for investors seeking a balance between risk and reward.

Types of Preferred Equity

Preferred equity comes in various forms, each designed to meet specific investment needs:

• Participating vs. Non-Participating: Participating preferred equity allows investors to share in a project’s profits, while non-participating preferred equity does not. This distinction can significantly impact potential returns.
• Soft vs. Hard Preferred Equity: Soft preferred equity is more adaptable and often used in a project’s early stages, where flexibility is essential. Hard preferred equity, on the other hand, is more structured and typically employed in later stages when a project requires a clear financial framework.

Preferred equity can also be categorized by purpose, such as development vs. acquisition.

Development preferred equity is used for financing construction and development, while acquisition preferred equity supports the purchase of existing properties. Each type plays a distinct role in real estate investments, offering tailored solutions for different project needs.

Strategic Uses of Preferred Equity

One of the primary uses of preferred equity in real estate investing is filling financing gaps. We often find that preferred equity is especially valuable in situations where traditional debt financing is limited or costly, allowing projects to secure additional capital without taking on restrictive debt.

Another strategic advantage of preferred equity is its role in risk mitigation and downside protection. By ensuring that investors are repaid before common equity holders in case of default or liquidation, preferred equity offers a layer of security. This structure aligns the interests of preferred equity holders with the success of the project, providing a predictable income stream and mitigating risk.

Moreover, preferred equity offers upside potential, especially for participating preferred equity holders.

These investors can benefit from returns above the preferred minimum, although this is typically capped. This combination of downside protection and potential upside makes preferred equity an attractive option for investors seeking a balanced risk-reward profile.

Market Trends and Future Outlook for Preferred Equity

The use of preferred equity in real estate has been on the rise, particularly in the commercial sector.

Investors are increasingly turning to preferred equity to mitigate risk and ensure predictable returns in a volatile market. This trend is evident as preferred equity fills financing gaps and provides additional capital in commercial real estate deals.

The impact of rising interest rates has further fueled the reliance on preferred equity. As traditional debt financing becomes less available, preferred equity offers a viable alternative, allowing investors to secure higher returns and more favorable terms in a competitive market.

Looking ahead, the future outlook for preferred equity is promising.

Continued growth is expected in the use of this financing instrument in real estate investments. As investors become more sophisticated in their understanding of preferred equity, we can anticipate more complex and tailored structures that effectively balance risk and reward.

Frequently Asked Questions

What is the main difference between preferred equity and common equity?

Preferred equity offers investors priority in receiving dividends and a higher claim on assets in the event of liquidation, whereas common equity does not offer these benefits. Preferred equity also often provides a fixed return, while common equity returns are tied to the company’s overall performance.

How does preferred equity compare to debt in terms of risk?

Preferred equity typically has a lower risk than common equity but a higher risk than debt. While it lacks the fixed repayment schedule of debt, it still offers investors downside protection through dividend priority and liquidation preferences.

Are preferred equity dividends guaranteed?

No, preferred equity dividends are not guaranteed. However, many preferred shares come with cumulative dividend features, ensuring that any missed payments are paid before dividends are distributed to common shareholders.

Why might a company choose to issue preferred equity over common equity or debt?

Preferred equity allows a company to raise capital without taking on the repayment obligations of debt or diluting control as much as common equity. It provides flexible financing, making it a suitable option for companies with fluctuating cash flows or specific project needs.

Conclusion

Preferred equity combines the benefits of both debt and equity, making it a valuable choice for investors who want stability with growth potential. With protections like dividend priority and flexibility in both private and public markets, preferred equity can help investors find a balance between risk and return.

Whether you’re looking to diversify your portfolio, invest in real estate, or explore new financing options, understanding preferred equity can help you make smarter choices. As markets change, preferred equity remains a solid option for both companies and investors, offering security and growth.