The best way to understand joint venture and preferred equity real estate investing is to plug in some real-world numbers. Let’s look at a scenario where a property costs $10 million, for easy math. Typically, traditional lenders will only mortgage up to 75% of the asset value, or $7.5 million in our example. To complete the $2.5 million balance, commercial real estate owners and developers may opt for preferred or joint venture equity financing models. To position your project for success, it is critical to understand the difference between these two models.
When it comes to strategies for investing in real estate, preferred equity and joint venture are among leading choices.
What Is Preferred Equity Real Estate Investing?
Preferred equity is part of what is known as the real estate “capital stack.” Essentially, this is a hierarchy that determines payment priority. For example, if a property generates positive cash flow or earns profits via a sale or refinance, the senior lender (i.e. the mortgagee) is paid first. Preferred equity is junior to the senior mortgage, meaning these investors are paid after. Remaining profits are then distributed to the common equity (i.e. shareholders).
Preferred equity holds a higher level of risk compared to the senior mortgage; however, the potential reward is a higher rate of return. It does carry less risk than common equity, however, and this can be appealing for many investors. Models typically include a fixed rate of return from net cash flow, as well as an accrual rate when a capital event takes place (e.g., a sale, refinance situation). While common equity investors stand to gain more in boom times, the upside to capping gains is that it insulates preferred equity investors from decreases in value. In other words, they’re able to better protect their downside.
For owners and developers, preferred equity real estate investing provides a higher level of leverage at a lower cost compared to common equity.
What Is Joint Venture Real Estate Investing?
Consider a scenario in which your company (Company A) acquires a property in LA county but you are based in the Midwest. You want to develop the land with a new office building, but you do not have much familiarity with LA’s real estate, industrial, and demographic makeup. Company B is based in LA County and has the knowledge and expertise required for a profitable project.
In this example, when you enter into a joint venture situation, Company A is responsible for taking care of capital needs while Company B leverages their specific know-how to get the project off the ground and position it for success. They are responsible for sourcing, closing, and executing the business plan.
If company A does not have the ability to contribute sufficient capital, they will need to find a capital partner. This partner will make investments with sponsors.
Company A is referred to as the “capital member” or “limited partner,” while Company B is the “operating member,” or the “general partner.” They form a joint venture partnership, a distinct entity that exists to support a specific property opportunity.
Unlike preferred equity real estate investing, joint ventures don’t typically offer a priority in terms of payment on capital events or distributions of cash flow. Proceeds are paid pari passu (which means “equal footing”). This is based on the initial investment percentages.
Say Company A invests 90% and Company B 10%. Proceeds and distributions are then paid 90% to Company A and 10% to Company B until a specified “internal rate of return” (IRR) is reached. At this point, Company A gives a “promote” or “carried interest” to Company B; this is equal to a disproportionate profit share. Company B then completes due diligence, works the closing, etc.
So, in our example, once a 10% IRR is reached, remaining proceeds are split 70% (capital partner, Company A) to 30% (operating partner, Company B). Company B’s additional 20% is the promote we mentioned above.
There may be more than one IRR requirement and additional promotes throughout the life of a transaction. These are referred to as “cash flow waterfalls.”
Joint venture allows you to share the risks of investment with your partner(s), access additional resources and markets, and leverage skill sets and experience that you do not own.
Considering Strategies for Investing in Real Estate
As you explore commercial real estate financing or investing opportunities, you will see both preferred equity and joint venture pop up frequently. We’ve provided an introduction into each and highlighted some key differences. The topic is complex and the decision is one of the most critical you will make when it comes to your project or portfolio.
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