Preferred Equity vs Common Equity: What I Learned From a Deal

Before we get into the definitions, here's one benefit of investing in deals with preferred returns. I'll get into why this works and the downsides of doing it too.

In this deal in 2022, I invested in a deal as a limited partner which had preferred equity. My investment amount was $50,000. Here is the year 1 depreciation amount I received.

What is common equity?

In an apartment syndication, these are your limited partners in a deal.

What is preferred equity?

Not to be confused with a preferred return, preferred equity is usually a large institutional size investor who invests money into a deal.

To the best of my knowledge, usually their structure is through a C Corp and so they don't get the tax benefits that the typical common equity investors get. The benefit is that their share of the depreciation is allocated to the other investors.

So for example, if the raise amount for a deal was $10M, $6M of that might be raised by limited partner investors. $4M of that might be raised from a preferred equity institution. The limited partners get the depreciation amount for the full $10M share of equity instead of the $6M they invested.

Why would preferred equity invest in a deal?

1.) It's a way to deploy a decently large sized investment amount.

2.) Often they want a guaranteed annual return that is favorable to them which accrues if not paid.

3.) Their equity portion has priority over common equity. If things go bad, they get paid first.

4.) Sometimes they negotiate some kind of control in the deal, or can take control if terms aren't met.

5.) Multifamily real estate is historically a great asset to invest in.

So how was I able to depreciate over double my investment amount?

1.) 2022 was the last year you can get the full bonus depreciation. 2023 it has 80% value and drops 20% thereafter. Expected depreciation was 90%.

2.) They received an additional tax incentive for this C class property. Expected depreciation was 110%.

3.) There was a preferred equity investor involved, so their portion of the depreciation was allocated to the common equity because they can't use it. Expected depreciation was 200% which was exceeded.

How is the capital stack structured?

Lender has first priority

Preferred equity has second priority

Limited partners have third priority

General partners have fourth priority

Downsides of preferred equity?

1. Sometimes their terms are aggressive in what they want in their terms and returns. They think that since they're bringing a larger portion of the equity that they should get better terms and usually do.

2. You don't want to accept too much preferred equity if they have a big enough portion to be a decision maker in the deal. Also if they're promised a high preferred return.

3. Preferred equity gets paid before the limited partners or general partners. If returns aren't good on the deal, the preferred equity could potentially take all of the profit.