As opposed to preferred equity, a joint venture equity partnership resides in the most junior level of the capital stack. A real estate capital provider (limited partner) will match their capital with the sponsor’s (general partner) and form a limited liability company to acquire a real estate project. The sponsor’s responsibility of the joint venture is to source, close, and execute the business plan on a specific asset class located in a certain geographic region where they have substantial expertise. However, the sponsor may not have the ability to contribute significant capital to the venture and will have to seek a capital partner whose main responsibility is making investments in these real estate opportunities with quality sponsors.
Joint venture equity is also different from preferred equity because there typically is no priority of payment on cash flow distributions or proceeds from a capital event. Distributions and proceeds are paid pari passu (Latin phrase meaning “equal footing”) based on the capital provider and sponsor’s initial investment percentages until certain internal rate of return (“IRR”) hurdles are attained. Once these IRR hurdles are achieved, the capital provider will give the sponsor a promote or carried interest, which is a disproportionate share of the profits. The sponsor receives this promote for acquiring the property, coordinating all of the due diligence/closing, guaranteeing the first mortgage, and executing the business plan established at the time of acquisition.
For example, a real estate capital provider and sponsor will invest 90% and 10%, respectively, of the total equity required for a real estate project. All cash flow distributions and proceeds are paid 90% to the capital provider and 10% to the sponsor (pari passu) up to a 10% IRR. The IRR is inclusive of cash flow during the holding period, a return of equity invested, and a return on equity invested. Once the 10% IRR is attained, the remaining proceeds are split 70% to the capital provider and 30% to the sponsor. This additional 20% to the sponsor above their initial equity contribution of 10% is the promote. Often times, you will see more than one IRR hurdle and additional promote opportunities, which is commonly known as a cash flow waterfall.
Preferred equity investments are in a junior position behind the first mortgage, but are in a senior position to the sponsor’s equity investment, often referred to as common equity. For example, when net cash flow is produced from a property or profits are earned upon a capital event (sale or refinance), preferred equity investors are paid after the senior lender, but before the common equity. Since preferred equity is junior to the senior mortgage, it carries a higher degree of risk and warrants a higher rate of return than the interest rate charged on the first mortgage.
Preferred equity can be structured in a number of different ways, but usually involves a fixed rate of return that is satisfied through a “pay rate” or “current pay” from net cash flow and an “accrual rate” that is typically paid upon a capital event. The returns of preferred equity investors are typically capped, so the common equity can reap most, if not all, of the profits after the preferred equity investors are paid. Conversely, preferred equity investors are willing to cap their upside by protecting their downside with a more secure position in the capital stack.
This is not an offer of securities and nothing contained herein should be construed as an offer to invest in securities or advice regarding investments.