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Numbers in the examples on this page are hypothetical and for illustration only. Return targets are not guarantees, and investors can lose money.

Preferred Return vs Preferred Equity

A preferred return relates to receiving priority treatment as it relates to the return on your initial invested capital. 

By contrast, in preferred equity, you would be in a priority position in the capital stack to receive your returns during the hold period and in a priority position to receive your initial investment back first when the asset is sold. 

In the right real estate investment profile, it might be a good idea to diversify a portion of your investments in a preferred equity investment to lower the risk profile of your overall portfolio. Remember, having 25% of your portfolio making 20% a year is great, except the other 75% is lazy equity, not making jack in your home, bank account, or stock portfolio. In that situation, bringing over a chunk of your 0-5% lazy equity to a pref equity position making 8-12% might really move the needle for you.

The risk is reduced since the preferred equity positions in the capital stack are typically only 10-30% of the overall equity portion of the capital stack. As a preferred equity investor, you would receive your specified return and your initial investment back before any of the other common equity holders. The tradeoff is that your preferred equity returns will be lower and upside limited compared to what common equity investors can receive due to the “less risky” position of your preferred equity in the capital stack.

Who is A1 and A2 for? Which one is for me?

We originally had the traditional equity (A2) option when we started to do alternative investments. It was very simple, just one option, and operated very similarly to most equity-based deals out there. Later, we realized that a small minority of investors might like the investment opportunity (asset/location/business plan), but they might want a more conservative option with a shorter time horizon and not want the upside.

Preferred Equity (A2) was born, which acts like a debt investment where you get a fixed rate of return with no upside (equity split), but oftentimes preferred equity holders get paid first and get to exit first. Every situation is different but this might be ideal for 1) mature investors with higher net worth (over $4m) who just wants to collect a steady income check or 2) new investors looking to move away from ordinary income private money lending or they need to show a skeptic spouse or themself that this alternative passive real estate investing world is real. Or even 3) a hybrid investor that wants to create some peace of mind with a steady income stream (some investors have taken HELOCs or home equity and want to put it to work in a less risky endeavor). I’ve personally done this with an investment opportunity that gave a 10% preferred return rate paid monthly. It does not give the highest potential returns, but I like how it pays my car payment, and I admit it just for my personal comfort, and not logical. And 4) Some investors who have a glut of lazy equity ($300k+) and really need to get funds moving and potentially get the majority of it back out in 1-3 years to then roll into a future traditional equity position in another opportunity. See “Pref Equity Timing” section below.

By now, you should have reviewed at least 5-7 past deal webinars. Seeing concepts like bridge loans, pref equity, and different slit schemes comes a live when you see it in a pitch deck or presentation.

We should have began with this at the top but as an investor you need to understand if you are investing as a 1) debt investor (see example video to right), 2) pref equity (paid like a debt investor but get a piece of depreciation/paper losses) or 3) equity (paid on the performance with some sort of a split of profits with GP/LP or waterfall). Confused? Don’t worry, it just takes some practice… review old “Past Deal” webinars here.

The Dark Side of Prefs

Investors generally like preferred returns because they usually put the passive investor first. But there can be a dark side to a preferred return. 

Here is the scenario, where I have seen other operators quietly play out:

An operator struggles on a deal out of the gate or something in permitting hits a snag (in a development deal) where the General Partners have multiple years of pref to pay out to LPs before they get paid. Ethics aside (putting LPs first), there is little motivation to run the deal because it is effectively a dead dog. 

As with most business plans, the end goal can be achieved, but it might require more time and something that the GP is not motivated to wait for, despite being best for the passive LPs. A possible solution (for a smart yet unscrupulous GP) would be to dump the asset prior to realizing the best pricing, which would require waiting more time and being buried under more years of a pref. 

This is why, as an LP, I really liked transparent split schemes like 60/40 or 80/20. It is fair for both the GP and LP. And if a pref is going to be used… it should only be used on stabilized cashflowing deals where you can point to the profit and loss statement and allocate the pref return payouts to LPs. Prefs should not be used on development or heavy value-add deals. But hey, anything goes in this world, and GPs need to throw in prefs to give their LPs a false sense of security.

Differences between Pref-Equity

This is going to confuse you if you do not understand the use of A1 or Preferred equity on the deal. Sometimes, you can have one large player take up the entire Pref Equity in a capital stack.