Modeling Preferred Equity

Preferred Equity is becoming increasingly more popular in commercial real estate. So how do you properly model this?

Preferred equity (PE) is the layer of a capital stack that sits in between common equity and the senior debt (or sometimes Mezz). Since we always read the capital stack from the bottom up, we can see that senior debt is always paid first, then preferred equity, and then finally common equity.

Often PE investors are providing a large chunk of equity, and therefore, want to get paid first (preferred position) before the common equity. By getting paid first, the PE provider is in a less risky position compared to the common equity investors.

Important:

PE is interesting because it has characteristics of both debt and equity. Meaning, preferred equity often gets paid a fixed rate of return (like debt) but can also still earn tax and depreciation benefits (like equity).


Modeling Preferred Equity:

Most often, preferred equity partners will ask for a set percentage return, an example being 16%. The PE partner might ask for a % to be paid every year (current pay) and a set % to accrue (until a capital event).

Example:

Amount: $3,000,000

Interest Rate: 16%

Current / Accrued: 8% / 8%

Current Pay:

Remember, PE is subordinate to your senior debt. In this example, you will pay $240K (8% of $3M) each year in current pay. At sale, the project would pay back the remaining principal balance ($3M) plus Year 3 debt service of $240K (assuming the sale is at end of Year 3). Any remaining cash flow is distributed to common equity.

Accrued Pay:

Accrued pay is the percentage return that is not paid every year. It simply accrues until a capital event such as a sale or refinance.

In the example above, the PE investor is charging 8% current and accrued, however, the 8% accrued portion ($720K) is paid at sale. $720K + the remaining principal balance of $3M is paid back at the end of Year 3. Any remaining capital is distributed to common equity investors.


Conclusion:

PE equity acts as additional proceeds to your deal, therefore it can increase your leverage on the deal. Since the PE investors earns a fixed rate of return, the sponsor and the common equity investors earn all of the upside.

No preferred equity investor is the same. Often times, modeling preferred equity is not as simple as I explained above.

  • PE investors may charge a different % return each year
  • The interest calculation could be different
  • Interest could be compounding / not compounding
  • PE investors could charge additional X% kicker at sale

Unfortunately, this may require you to model the preferred equity terms manually in your underwriting model to have the most accurate analysis.