Most investors want to create the most potential and upside for their investments while limiting the risk they take on. Diversifying their portfolio through asset classes as well as passive or active investments are the traditional methods.
Often we see investors who engage in real estate as a whole. For example, they diversify by owning single-family homes as rentals (active), while also investing in real estate syndication deals as Limited Partners (passive). This allows them to have varying risks and time horizons for their investments. A less-known option of diversification involves investing in different parts of the capital stack.
The capital stack ranges from the least risky with the highest priority to the riskiest with the lowest priority. Investors have the option to diversify their portfolios by selecting either preferred equity or common equity. The choice between the two depends on factors such as the economic climate, deal dynamics, and desired return profile. In this article, we delve into the nuances of investing in preferred equity versus common equity, the pros and cons of each position, and the risks associated with them.
The Capital Stack
A Multifamily syndication deal involves a structured hierarchy of funds essential for completing the transaction. In other words, a layered approach to financing the property. First to contribute is debt, such as mortgages and loans, most often agency debt (Freddie or Fannie). The second is preferred equity. This is where most institutional investors choose to invest their money. The third tier is occupied by common equity, which is the conventional investment path for Limited Partners (LPs). At the bottom of the capital stack is the General Partnership. These positions delineate the order of repayment for investments and loans and the distribution of profits.
Investing in Preferred Equity
Preferred equity sits above common equity in the capital stack providing a key advantage. Through the hierarchy of the capital structure preferred shares receive priority in the distribution process. They are typically receiving significant cash flow. Additionally, in the event of a default or bankruptcy, the preferred equity holders would be paid before the common equity holders; therefore they carry less risk.
With these advantages, institutional investors tend to opt into the preferred equity position. It is considered more reliable with a steadier rate of returns and is less likely to be reduced or eliminated compared to common equity in times of turbulence.
The Cons of Preferred Equity
Like any investment, preferred equity carries inherent risks, albeit lower than those associated with common equity. In situations such as a recession or increased bad debt (unpaid rent), if a property lacks sufficient cash flow to cover operational expenses, the operator may opt to withhold distributions. If this happens, preferred equity investors may see changes in distributions or a pause altogether. Fortunately, they are prioritized over the common shares so they may not see the same timeline for these disruptions. Unlike agency debt, another risk for preferred equity lies in the absence of property collateral. This lack of collateral implies that in the event of property bankruptcy, there is no recourse or guarantee of profit through returns. This is a notable difference from debt who holds the land and property as collateral and would take ownership if the property went bankrupt.
Investing in Common Equity
Common equity serves as the conventional investment framework for Limited Partners (LPs) in Multifamily investments. This represents the third tier in the capital stack hierarchy. Consequently, it bears the highest level of risk, but it also presents the greatest potential for returns. Common equity typically participates in both capital returns and cashflow distributions- a noteworthy benefit. Within this asset class, sub-levels like classes A, B, and C further delineate the priority of distributions and risk profiles.
Common equity offers notable advantages, such as the potential for exponential equity and value appreciation. One example was during the 2008 economic downturn, during which many common equity investors took calculated risks and invested in defaulting properties at historically low prices. Through value appreciation, these investments yielded some of the largest returns in history. The upside potential for long-term profits in common equity investments is one of the most attractive reasons investors choose this position.
Cons of Common Equity
The primary drawback lies in the positioning of common equity within the capital stack. In the event of bankruptcy or liquidation, common equity is the last to receive compensation and has the highest risk of total loss. Another disadvantage is having the highest probability of distribution holds. Being at the bottom of the capital stack means they are the first to lose returns, to ensure the debt is paid and preferred equity holders receive their shares. The third challenge mirrors that of preferred equity, involving the absence of collateral. If the property faces financial distress and the operator cannot meet the loan terms, there is no certainty or guarantee of receiving returns.
Preferred Equity vs. Common Equity: Which is Better?
Determining the optimal investment in the capital stack lacks a one-size-fits-all solution. Your choice depends on risk tolerance, the importance of secure returns, and the overall upside potential you seek. Assessing these considerations will guide your investment decisions. Although both options carry inherent risks, if your priority is the safest investment, preferred equity emerges as the suitable choice for you.