The Security of Preferred Equity in Multifamily Investments: A Guide for Passive Investors

In the world of real estate investment, preferred equity has become a popular choice for investors seeking a balance of stable returns and a layer of protection against downside risk. Multifamily properties, in particular, provide an ideal landscape for preferred equity investments, given their resilience, steady cash flow, and growing demand. This article explores how preferred equity works and why it’s considered a secure option within multifamily real estate investments.

Understanding Preferred Equity in Real Estate

Preferred equity is a unique investment position in the capital structure of real estate deals. Unlike common equity, preferred equity holders enjoy priority on returns and often have additional protective rights. While they don’t have the complete debt-like security of a senior loan, preferred equity investors sit above common equity holders in the capital stack, making it a relatively safer position compared to standard equity investments.

This prioritized placement allows preferred equity holders to earn a fixed, predictable return that is typically paid before any distributions are made to common equity investors. This setup appeals to investors who prioritize regular income over potentially higher but less reliable returns.

Why Preferred Equity is Considered Secure in Multifamily Investments

Multifamily real estate offers a variety of inherent benefits that bolster the security of preferred equity, including:

1. Steady Demand and Cash Flow
   Multifamily properties generate income from rental payments, providing a steady cash flow that supports regular returns. Given the continuous demand for housing and the growing trend toward rental living, multifamily properties are widely regarded as one of the most resilient asset classes in real estate. This stability helps to protect preferred equity investors, as there is generally a consistent flow of funds to cover their returns.

2. Priority Return Position
   One of the most significant security benefits of preferred equity is its priority in the capital structure. This priority means that preferred equity investors receive their returns before any common equity holders. In a multifamily deal, the revenue from rental income typically covers the operating expenses and preferred returns first, ensuring that preferred equity investors are paid before other stakeholders benefit.

3. Protective Rights
   Many preferred equity investments come with additional protective rights. For instance, preferred equity investors may have certain "cure" rights that allow them to take action if the asset underperforms or the property management fails to meet operational standards. These rights add a layer of control, giving investors greater protection over their capital.

4. Downside Protection
   In the event of a market downturn, preferred equity remains a safer position. Should cash flow tighten, preferred equity holders are still paid before common equity holders, making it more likely that they will continue to receive income even when property performance dips. This priority helps shield preferred equity investors from some of the volatility that can affect traditional equity positions in a market downturn.

5. Accrued Returns as a Safety Net
   In addition to consistent income payments, some preferred equity structures include an accrued return component. If the income from the property cannot cover the current preferred return, the unpaid portion is added to an accrued balance, which must be paid out to preferred equity holders before common equity holders receive distributions. This feature adds a level of "make-up" protection, ensuring that preferred equity investors eventually receive their targeted returns.

Comparing Preferred Equity to Common Equity and Debt

It’s helpful to consider preferred equity's risk profile in the context of common equity and debt:

• Common Equity: Common equity holders receive returns only after debt and preferred equity obligations are met. While common equity can offer higher returns, it also carries more risk. In a challenging market, common equity holders may receive little or no return if there isn’t enough cash flow after satisfying senior obligations.

• Debt: Debt holders, such as banks or bondholders, have the highest priority in the capital stack and are repaid before all equity holders, making it the most secure investment. However, returns on debt are generally fixed and may not capture the upside of property performance.

Preferred equity sits in between these two positions, offering a blend of protection and upside potential. It appeals to investors seeking a steady return with a reasonable level of security, while avoiding some of the restrictions and lower returns associated with debt.

The Preferred Equity Advantage in Multifamily Real Estate

Given the current economic climate, preferred equity investments in multifamily properties have become an attractive option for investors looking to balance income with security. Multifamily properties have shown strong resilience even in economic downturns, largely due to the essential need for housing and consistent rental demand.

Multifamily preferred equity investments also provide a powerful advantage in risk-adjusted returns. Investors gain a reliable income without the full exposure to market fluctuations that common equity holders face, while still benefiting from the growth of the property.

Key Takeaways for Passive Investors

Preferred equity in multifamily real estate offers several compelling advantages for passive investors:

• Stable Returns: Preferred equity provides a fixed, predictable income stream, making it an excellent choice for income-focused investors.

• Capital Protection: The preferred position in the capital stack and accrued return feature serve as protective measures, helping to safeguard investor capital.

• Reduced Volatility: Multifamily assets are known for their resilience, and preferred equity's seniority helps reduce exposure to market shifts.

• Access to Real Estate’s Upside: While preferred equity isn’t as secure as debt, it offers a balance of income and growth potential that’s particularly valuable in the growing multifamily sector.

By prioritizing preferred equity in multifamily investments, passive investors can achieve a blend of income, security, and steady growth that aligns well with long-term investment goals.

Preferred equity is a smart choice for those looking to benefit from the growth of multifamily real estate while enjoying a secured, predictable return. As investors continue to seek out resilient, income-generating investments, preferred equity in multifamily properties stands out as an attractive option that delivers stability, security, and dependable income.

Boosting Cash Flow with PFC Tax Abatements

Public Facility Corporation (PFC) tax abatements provide a valuable tax incentive for multifamily properties, significantly reducing property tax liabilities. By working with a PFC, a real estate developer or property owner can secure a tax exemption, often in exchange for offering a portion of the units as affordable housing. This abatement can make a substantial difference in a property’s cash flow, directly benefiting preferred equity investors by increasing the available funds for consistent, timely returns.

Here’s how PFC tax abatements strengthen cash flow and improve the reliability of preferred equity payments:

1. Lower Operating Costs
   Property taxes are one of the most substantial expenses in multifamily property operations. By securing a PFC tax abatement, the property can reduce this expense significantly, often by as much as 80-100%, depending on the agreement and local regulations. Lower operating costs mean that more of the property’s rental income can go toward investor distributions and property improvements, supporting consistent preferred equity payments.

2. Enhanced Cash Flow Stability
   With reduced tax expenses, the property experiences increased net operating income (NOI), which improves the overall financial health and stability of the asset. This consistent cash flow is crucial for meeting preferred return obligations, providing preferred equity investors with a reliable income stream.

3. Greater Coverage for Preferred Payments
   The improved cash flow from PFC tax abatements means that properties can more easily cover their preferred equity obligations, even during economic downturns or periods of high vacancy. This security benefits preferred equity investors by creating a stronger buffer for payments, ensuring they’re prioritized in the distribution waterfall and receive their returns on time.

4. Potential for Higher Return on Investment (ROI)
   The tax savings achieved through PFC abatements can be reinvested in property enhancements or other value-add strategies, further improving the property’s attractiveness, occupancy rates, and rent potential. This potential increase in revenue enhances overall returns, indirectly benefiting preferred equity investors by supporting property growth and stability.

5. Reduced Risk Exposure
   The extra cash flow generated by tax abatements also provides an added layer of protection against market volatility and economic downturns. Properties with PFC abatements are less vulnerable to financial distress, as they have lower fixed costs to cover each month. This reduced risk exposure aligns with the priorities of preferred equity investors, whose goal is to achieve steady, secure returns.

PFC tax abatements enhance multifamily properties by decreasing operating expenses and increasing cash flow, making it easier for property owners to meet preferred equity obligations. This financial advantage provides preferred equity investors with an added layer of security, ensuring a consistent income stream backed by the strong cash flow dynamics of the property.