Preferred vs Common Equity Explained: Differences Plus Which Equity Type is Best for You

Equity funding is a big part of the real estate capital stack. Without it, few commercial properties would get built. That’s why every investor and developer should know the ins and outs of common equity vs. preferred equity in real estate.

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The truth is that commercial real estate investing is as much about property as it is about CRE financing. This is especially the case in today’s CRE market, where positive sentiment is building but:

• A debt crunch looms as $575 billion in CRE loans is set to mature in 2025, First American estimates
• Many commercial properties that require refinancing are valued below their original financing valuation
• Institutional lenders remain tight-fisted until market fundamentals further improve

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In this challenging climate, equity funding can help fill existing financing gaps where banks fail.

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Securing funding through equity can also mean seizing new investment opportunities instead of sitting on the sidelines watching property value creep back up across asset classes. 

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So what is common equity, what is preferred equity, and where do they fit in the capital stack? Let’s look at the pros and cons of these different types of investment structures and how they compare in terms of risk and potential returns. 

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Read on for a detailed breakdown of common equity vs. preferred equity in real estate.

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In need of short-term capital to close an equity deal? By signing up with Duckfund, you can borrow up to $100 million for debt and equity deals across all property sectors.

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Preferred and common equity in the capital stack

Securing commercial property financing isn’t all about taking on purchase or refinance capital with commercial lenders. Next to debt, equity is a main component of commercial real estate investing. Investors can choose to take equity positions in a commercial real estate project. 

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What does that mean for an investor? That depends on the equity structure they’ve chosen.

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Equity investments come in two types of financing – preferred equity vs common equity – in real estate:

• Preferred equity is a medium-risk investment position that offers priority dividend payments and fixed returns, sitting below debt but above common equity in the capital stack.
  
  
• Common equity is the highest-risk position at the top of the capital stack, offering unlimited upside potential but receiving distributions only after all other obligations.

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Each type of equity has its position in the commercial real estate capital stack This top-down stack offers a handy way of representing the financial structure of a commercial real estate deal and of determining an investor’s return on investment versus the degree of risk taken on. 

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Debt in the capital stack

At the bottom of this financial layer cake sits senior debt or mortgage financing from commercial banks. This part often represents the largest portion of the capital stack and is the safest bet for lenders, earning the lowest interest rate but coupled with the lowest risk. That’s because debt obligations are paid first and a senior loan is secured against the asset if the borrower defaults. 

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Mezzanine debt sits in the middle of the capital stack, giving mezzanine lenders payment priority over equity and after any debt obligations to senior lenders. Provided by institutional investors looking for higher yield, mezzanine debt receives a higher fixed rate of return than senior debt and is also exposed to a higher level of risk. 

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Usually, the downside protection of a mezzanine loan is the right to equity if the borrower defaults. 

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Equity in the capital stack

Topping the capital stack – in both risk and potential return – is equity. Unlike lenders, preferred equity investors receive a share of the commercial property and only earn returns when all debt obligations are met. Preferred stock is often promised a minimum return before common equity holders are paid.

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Sitting at the top of the capital stack, common equity investors accept the most risk in return for the highest potential. They’re only paid after fund distribution among all other parties – but that means higher returns if the real estate project does well. 

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Common equity is usually held by the investors behind the commercial real estate deal and/or their sponsors. These two parties are the General Party and the Limited Party.

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Understanding your position in the capital stack is key to assessing the risk and potential returns of your investment.

Comparing preferred equity vs common equity in real estate deals

The choice between taking a common and preferred equity position can significantly impact the outcome of your commercial real estate investment. Let’s break down the 4 main differences of these equity structures:

1. Default) risk for preferred equity vs common equity

The level of risk in a CRE deal is measured by the level of seniority and downside protection of an investment relative to other parties. Debt has seniority to equity, putting equity holders at significantly higher risk than other parties. 

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While equity is always subordinate to debt, preferred equity investments do have seniority to common equity investments. In the case of a default or liquidation, preferred equity holders would get paid out before common equity holders – if anything is left after debts have been settled, that is. 

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This means that, in practice, common equity holders are often left with nothing after a foreclosure. 

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2. Priority in distributions to preferred equity vs common equity

Equity holders have lower priority in dividend distributions than debt. The upside of holding preferred equity vs common equity in real estate isn’t just that dividend payments can be higher over preferred stock – but also that they can have an arrearage feature included. 

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In the case that the equity issuer fails to pay dividends – let’s say operating expenses are higher or development takes longer – the preferred equity holder is entitled to receive late dividend paid in arrears before future dividends can be paid out. 

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Common equity holders don’t have this benefit. That makes preferred return on dividends both steadier and higher, adding a strong cash flow argument for.

3. Upside potential on common equity vs preferred equity in real estate

While preferred equity carries less risk and steadier dividend returns, there’s one major drawback of holding preferred equity vs common equity in real estate – that’s limited upside. 

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Any property value increase over time is not reflected in the fixed dividend payment to preferred stock, while common equity holders will see dividend and share prices increase as a commercial real estate project becomes successful. 

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The best thing about common equity is there’s no cap on upside potential. This potential is why common equity has the highest internal rate of return on average – and why investors are drawn to its potential for long-term value (LTV). 

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4. Ownership interest and preferred equity vs common equity

Another difference between common and preferred equity lies in ownership interest. While both equity structures have ownership interest and neither have their interest secured in case of a default, common equity typically has voting rights. 

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This gives common equity holders influence over the course of the commercial real estate project. 

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Preferred equity vs common equity: Which is the better investment?

For commercial real estate investors, choosing between preferred equity and common equity comes down to two things: risk tolerance and return expectations. 

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Not anyone can afford or is willing to take on risk involved with equity. That’s even more the case in a real commercial real estate market with high delinquency rates, where borrowers are falling behind on their repayment. 

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Overall delinquencies of commercial mortgage-back securities (CMBS) have increased over 45% in a year to reach 6.57%, as data CRE analyst Trepp shows. Multifamily delinquencies are up nearly 75% and have more than doubled in the office sector. 

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Source: Trepp 

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Can you afford the risk exposure of common equity? If you have a high risk tolerance and your portfolio can weather potential losses, then the upside potential might be worth the risk.

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If you’re more conservative and are looking for a steady, more predictable cash flow then preferred equity might suit you better. Fixed dividend payments mean you’ll start seeing returns earlier in the life of the investment. You can then reinvest this cash flow to compound your profits.

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While potentially incredibly lucrative, common equity might not bring investors a short-term cash flow. Common equity holders will have to wait longer to see any potential returns. 

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Considering the CRE project type and its stage

Risks and rewards differ wildly between CRE projects. Depending on the project type and the stage it’s in, taking either preferred or common equity could make more sense for investors. 

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Investors should always examine the project closely before considering what equity structure fits them best.

• For core or core-plus properties that are already stabilized and generating income, preferred equity might be a good fit
• For value-add or opportunistic investments, common equity might be more appropriate. These projects often require more capital and carry more risk, but they also offer the potential for higher returns
• If you're comfortable with the risks associated with development projects or distressed assets, common equity could be your path to significant capital appreciation (or losses)
  
  

The importance of equity funding in closing CRE deals

In the CRE business, equity plays a big role in bringing deals to fruition. Equity financing is especially important in today's commercial real estate market, where traditional lenders are more cautious.

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Equity allows developers to raise substantial capital by selling ownership stakes in their projects, filling funding gaps that could otherwise derail promising ventures. The flexibility in offering property shares is a big plus in CRE deals.

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Developers can combine and balance preferred equity vs common equity in the real estate capital stack to draw in investors while maintaining control of their projects.

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This flexibility is exactly what Anna Kogan, CEO of Duckfund, aims to provide by adding equity and debt financing to their CRE financing solutions. 

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“We want to help our customers increase the chances to close the deal,” Kogan told news outlet Commercial Observer. “We help to put the deal under contract and then we kind of hold their hand in the equity syndication process as well through our chains of trust of our partners, our relationship with equity places and people who are interested in providing equity and participating in deals as general and limited partners.”

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Offering a comprehensive solution that spans the entire deal process, from contract to syndication, makes Duckfund a valuable partner for CRE professionals looking to close deals in an uncertain CRE environment.

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For instance, the Duckfund provided an investment group with $240,000 in earnest money to help win a competitive bidding process, followed by a $3M equity solution to close the deal. This helped the client rapidly grow their portfolio without locking a big chunk of their personal funds.

[Finding a great commercial real estate deal can be hard in today’s market – and closing one even harder. Duckfund’s equity financing of up to $100 million in just five days helps you secure the deal from start to finish.]