Preferred equity is a powerful means of aligning incentives between real estate investors’ interests, the developers/operators driving the project, and iFunding’s real estate crowdfunding platform. How does it work exactly?
First, real estate investments can be divided into equity deals and debt deals. Equity deals give investors participation in the profits and losses on a building or project. Debt deals function like a private loan, or mortgage, with an interest rate returns. Within equity deals, one component of the return is “preferred equity” and the second is “common equity” or the “profit share.”
Preferred equity means that, after a project covers costs-to-date and begins generating profits, the first x% (typically 8-10%) of profit is shared only with investors who have contributed capital. The main component of the project operators’ profits only begin after this initial profit is paid to investors, motivating them to manage costs well, focus on the most attractive enhancements, and generate profits that are better than “good.”
Note that the developers also may commit cash to the project and be modest equity holders. This is valuable to the deal because it reinforces the developers’ commitment to seeing a project through and gives them more of the perspective of the other investors. If so, they also will receive a proportional (commonly 5-10%) share of the preferred returns, to reflect their complementary role as equity investor.
After the preferred equity return is distributed, remaining profit is split between the investors and the project operators/administrators. The ratios will vary depending on the project – its size and complexity, operator demands and financing needs – however the investors typically receive between 30% and 70% of the profit split above and beyond the preferred share.
Let’s look at an example: Take a project that cost $200,000 all-in (equity invested was $200K), and profits after all costs – construction fees, closing fees, brokers fees, insurance as well as transaction fee – was $50,000. The stated preferred return is 10% and subsequent profit share to investors is 50%. Investors would receive $200,000 in return of their original investment, plus $20,000 in preferred equity (10% of $200,000) and plus one-half of the remaining $30,000 profit. If costs turned out to be $10,000 more, it wouldn’t affect the return of 10% preferred, but the remaining profit to split would be reduced from $30,000 to $20,000.
iFunding’s project administration fee is included in the overall calculation of profits and costs and is always line-itemed in the pro forma spreadsheet and in a deal’s operating documents. All costs including this service charge are accounted for in calculating your overall returns (preferred plus profit share). After listening to our investors’ feedback, we further have arranged for the service fee to factor into the basis of preferred equity, in effect increasing the target preferred monetary return.
With equity investments, please remember that while average returns tend to be noticeably more attractive then with debt, your original capital is not guaranteed, as you are participating (usually as a member in an LLC) in the profits or losses on a projects. However, preferred equity strengthens the likelihood of profiting, since real estate projects generally are backed by the land and existing building assets. Overall, preferred equity deals are a common type of investment opportunity that has been traditionally available only to institutional-class investors and very high net-worth individuals. iFunding is pleased to make these types of opportunities available to all of our accredited investors.