Updated · Part of the CRE investment glossary
How preferred equity works
A sponsor who needs more capital than the senior loan and the common equity provide can sell a preferred membership interest in the company that owns the property. The preferred investor puts in a fixed amount and is paid a stated return before the common investors (the LPs and the sponsor) receive anything. At the redemption date, or at an earlier sale or refinance, the preferred investor is repaid its capital plus any accrued return.
Because it is equity, the preferred investor has no lien on the property and no pledge to foreclose on. Its protection is contractual: consent rights over major decisions and, if the sponsor misses payments or the redemption date, the right to remove the managing member and take control of the company.
- Hard preferred equity: fixed current pay, a firm redemption date and strong control remedies. In practice it behaves much like mezzanine debt.
- Soft preferred equity: paid from available cash flow, with a longer or flexible redemption and sometimes a share of the upside. It behaves more like a senior class of equity.
The formula
The return is usually split into a current-pay rate, paid in cash each period, and an accrual rate that adds to the amount owed at redemption:
Redemption amount = preferred capital + accrued unpaid return (+ any exit fee or minimum-multiple top-up)
- Current pay each year = preferred capital × current-pay rate.
- Accrual each year = base × accrual rate; the base is the capital alone (simple) or capital plus prior accruals (compounding).
- Exit fees and minimum multiples are negotiated per deal; many deals have neither.
Worked example: 13% preferred equity, three years
A sponsor raises $2,000,000 of preferred equity at a 13% return: 8% current pay and 5% simple accrual. Each year the property pays $160,000 in cash to the preferred investor and $100,000 accrues. The investment is redeemed at the end of year three.
The preferred investor receives $480,000 of current pay plus $2,300,000 at redemption, $2,780,000 in total, or 1.39x its capital. If the accrual compounds annually instead, the accrued balance after year three is $315,250 rather than $300,000. The rates are assumptions for the example, not market quotes.
| Year | Current pay (8%) | Accrual (5%) | Accrued balance | Redemption if repaid now |
|---|---|---|---|---|
| 1 | $160,000 | $100,000 | $100,000 | $2,100,000 |
| 2 | $160,000 | $100,000 | $200,000 | $2,200,000 |
| 3 | $160,000 | $100,000 | $300,000 | $2,300,000 |
Preferred equity vs mezzanine debt
Both fill the gap between the senior loan and common equity, and their pricing often overlaps: each is priced well above the senior loan, and quotes vary by deal and by month (see the PeerSense source below). The differences are legal. Mezzanine debt is a loan secured by a pledge of the ownership interests, so the lender can foreclose on that pledge. Preferred equity is an ownership interest, so the investor takes control through the operating agreement instead.
Some senior loans restrict additional debt but allow preferred equity with the lender’s approval, which is one reason sponsors choose it. Either way, the senior lender usually wants to approve the terms.
What to watch for
Preferred equity changes what the common investors receive, so read its terms alongside the waterfall:
- Mixing up preferred equity (a separate, senior class of capital) with a preferred return (a tier in the common equity waterfall).
- Modelling only the current pay and forgetting the accrual that comes due at redemption.
- A redemption date earlier than the business plan’s sale or refinance date, which can hand control to the preferred investor.
- Cash sweeps and consent rights that limit the sponsor’s decisions while the preferred equity is outstanding.
- Common investors sit behind the preferred layer, so their returns fall faster when the deal underperforms.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.