Investors’ Benefits from Preferred Equity in Real Estate Deals

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.

Comparing Preferred Equity vs. Debt – for Real Estate Investors

One of the important decisions that investors make with real estate is whether to invest via equity or debt. This post describes key differences between these types of investments, and why iFunding has chosen to specialize in preferred equity financing, which we feel is the most attractive blend of returns and control for many investors.

What is preferred equity vs. debt investing?

First, definitions, which you can skip and go to the comparison, if you’re comfortable with preferred equity and debt investing:

Investing via equity in real estate means that you are a shareholder in a project. The project, be it a home refurbishment, a retail space, or office tower, generates profits through some combination of increase in price between purchase, improvement and sale, or via tenant rental income. You as the equity investor receive a share of the net profits after expenses, and the profits also are shared with the project developer/operator, and the promoter or crowdfunding platform. Many equity investments, including most of those from iFunding, include a “preferred equity” component: from any profits after project costs, the first cut is returned solely to the investors, not to the developer for their work. In the real estate investment sector, preferred equity often is set at 8-10% target return. After preferred equity profits are paid out, the remaining profits typically are shared at 30-50% going to the project’s operating partner, and the remaining amount to the investors (50-70%), with a modest fee going to the crowdfunding platform.

In addition, there are significant financial benefits to equity investing in that when property depreciates, investors can participate in the on-paper losses to offset other income they have. Also, longer-term profits may be taxed at long-term capital gains rates. We’ll cover these considerations in another post.

Investing via debt means that a loan is provided to the project operator. The investors receive a fixed rate of return. The payback of the loan is usually guaranteed against the property asset itself. That is, this is a mortgage similar to what you’d have on your own home. Instead of directly listing the investor as a lender, however, in crowdfunding the invested money is pooled in an entity such as an LLC and this entity lends the money to the project operator.

How to decide on preferred equity vs. debt investing?

  • Returns: Typical returns on equity investment in real estate can range from 18% to 40%, annualized, or more. Typical interest rates on debt, or lending, currently range from 8% to 13%, annualized, in the crowdfunding business.
  • Principal: With equity, investors participate in the profit or loss on the project, much like stock you hold can go up or down in value. The investor would want to be comfortable with this dynamic. Real estate debt is generally considered somewhat safer, as it behaves similarly to high-yield corporate debt. Principal is intended to be repaid regardless of project profits, but there are situations in which a borrower may default and foreclosure proceedings occur over the assets.
  • Investment duration and payment frequency: Equity investments and debt both are available with short term returns, such as house refurbishments completed in a few months, and on longer term holds, usually commercial property spent with rental and upgrade potential. Profits returned on equity investments often tend to be paid out quarterly or annually and with a significant lump sum at the end (sale) of the project. Interest on debt usually is paid quarterly or monthly, sometimes annually, in the crowdfunding world, again with a lump sum return of capital at the end of the loan.

Questions to Ask Crowdfunders

While equity and debt are relatively straightforward to understand, there are nuances, especially in the crowdfunding world, that you’ll want to ask your fundraising platform about:

If equity:

  • How much oversight and control does the crowdfunding platform have over each project? If the project is sidetracked for any reason, what ability does the crowdfunding platform have to identify the issue and direct it’s resolution? At iFunding, our company serves as the manager of the entity overseeing the project. iFunding holds title over the property in nearly every case, so the property itself is part of the guaranty underlying investors’ principal.
  • Is the investment individually structured for protection? investors should prefer that the property title and their funds are held in a corporate entity set up solely for the purposes of the one project. That is, any financial issues with other projects or with the crowdfunding company itself should not affect the ownership, liens on, or reliability of a particular investment. iFunding structures its offerings this way, through “single purpose entities,” which continue as viable, legally-protected entities regardless of the status of other investments or the company itself. iFunding does not create a more complicated structure, with the property/project in one LLC, and the financing in another LLC that invests in the first. Other crowdfunding sites have taken this two-tier approach, however unwinding them or otherwise following the property ownership and lien structure (should that be required on a difficult project) can be more complex .
  • What’s the term of the investment? Equity investment durations can range from a few months to several years on the crowdfunding sites. Different durations will interest different investors. Be aware that longer term investments, such as larger commercial properties, can both be more stable, in that existing properties have a demonstrated operating track record of occupancy and cash flow. However, investments that are committed for years are more subject to macro-economic trends which can cause ongoing returns and final value to fluctuate.

If debt:

  • Do the investors have a true guaranty on the property? In some cases, crowdfunders actually give investors a promissory note, which says that the crowdfunding company promises to pay the investor — as long as the project operator first pays the crowdfunding company. It’s the crowdfunding company only that has a guaranty. The investors don’t have direct control over the assets should investor repayments stop and the property needs to be foreclosed. But, how aggressively will the crowdfunding site pursue foreclosure and return of investor’s money?
  • What happens if the crowdfunding company is no longer available to make payments, is unable to make timely payments, or closes itself? Have the site explain their backup processing plan if they are no longer in business, and confirm whether the switchover to the backup plan is automatic, or depends on the crowdfunder being involved to take action. In these two preceding situations, the security of debt investing may be less than in traditional real estate lending, where the investors have direct property title or borrower guaranty.
  • Your ultimate return on real estate debt also depends on how long the interest accrues. If a project, like a home refurbishment, is completed and sold ahead of schedule, a loan that you thought would yield interest for a year may only provide interest for a few months. If so, you’re actual return after taking the time to research and invest in the project (and cost of a wire of funds), may be just a few percent. At a minimum, ask the crowdfunding site whether pre-payment (early loan completion) premiums are paid by the real estate operator and passed back to the investors in this case. Also, calculate your likely absolute return as well as an annualized rate.

The Case for iFunding and Preferred Equity

Experts recommend that sound investing involve diversification of your portfolio, both across asset classes such stocks, bonds and real estate, and within a class, that is, different property types, locations, investment durations, and equity vs. debt structure. So there’s certainly room, and benefit, to hold a variety of investment types and hold both equity and debt. iFunding offers both but specializes in preferred equity.

Our investors tell us that, the more comfortable they become with real estate, the more they appreciate the combination of potential returns and control that iFunding can offer through preferred equity deals. We offer a range of property types across the nation, with many being shorter-term, smaller budget equity investments. A “preferred equity” component means that the first distribution of profits goes to the investors, putting individuals like yourself on par with what financial institutions traditionally have received in equity investment terms. Finally, we believe we lead the industry in oversight of project and frequency/detail of reporting on project activity, increase the quality of project and investment results and increasing your comfort about investment status.

Read a step-by-step explanation of the iFunding investment process here.

Preferred Returns – What’s The Point?

Often people that are new to investing think that real estate transactions have to necessarily be overly-complex and abstruse. After all, most private equity deals are laden with large operating agreements, private placements, subscription agreements and rather complicated legal documentation. There is certainly no denying that all of this documentation can be burdensome for a layman and thus the SEC and state securities commissions want to make sure that promoters must follow strict rules when soliciting investors for money. Investor protection is a paramount concern and the regulators despise the concept of guarantees or anything that smacks of an unrealistic amount of return a project can deliver.

Truth be told, no investor no matter their level of sophistication can guarantee anything. The world is simply too complicated and there are uncontrollable risks like the mortgage crisis, geo-political risks, currency risks, inflation risk, etc. that at times will drastically impact a given project in ways that the promoter could have never foreseen. If you examine a properly documented private placement it will specify tens or hundreds of things that can possibly go wrong. It is kind of like watching a pharmaceutical commercial where they spend 90% of the commercial telling you how perfect the drug is and the last 10% listing all of the side effects and what can go wrong.

So if a promoter can’t look into their crystal ball and tell what is going to happen in the future and they can’t guarantee anything what is the next best things they can do? Enter the concept of a preferred return. A preferred return is simply a benchmark threshold an investment must hit before the promoter is able to participate in any profits. So if the threshold is set at 8% this would mean that the investment has to return this amount before any participation would be realized by the promoter. It is then typical for the remaining profits to be split in some fashion among the investors and the promoter based on what was specified in the agreements.

One of the primary concerns you as the investor should have when investing in a syndicated real estate transaction is alignment. Heavy fees in projects can create misalignment between those supplying the capital and those utilizing the capital to invest in a given project. A certain grade school sense of fairness should be applied in all situations. A preferred return helps to create alignment along with fairness in a real estate profit sharing arrangement. The investor has preference to any pool of profits that comes from a project and the promoter is only allowed to participate if they deliver enough dollars on the money invested for there to be excess after the preferred minimum is paid. Thus promoters will only select projects with that will clearly clear the hurdle of the preferred return so they can maximize their chances of being able to participate in projects.

An investor that wishes to create additional alignment should carefully examine whether or not the fees to the promoter are paid before or after the preferred payments as well. Payment of fees prior to preferred payments could potentially incentivize the promoter to take projects that maximize their chances of making fees instead of the ones that will make the most money for the shareholders. This is a classical problem with real estate brokers who operate under straight commission. The true goal of those operating under this structure is to err on the side of making sure the transaction happens instead of making sure the project is the best one for those with the money at risk.
In summary, investors should seek maximal alignment between themselves and the promoter asking for them to invest their hard-earned money. There are many things that should be closely examined in complex real estate structures, but one of the primary things investors should scrutinize is alignment. Preferred returns help to create alignment as does making sure that the promoter largely gets paid at the same time as the investor instead of deriving much of their income from fees that are payable regardless of how successful the transaction turns out. Following these high-level guidelines when examining investments will serve to protect you when you choose among many investments available.


This article is a guest post from Bryan Hancock, head of the Acquisitions Department for Bullseye Capital’s Real Property Opportunity Fund.

The information contained in this article is not to be construed as constituting tax, legal, accounting, financial or investment advice.