What is preferred stock and how do I invest in it?

May 1, 2024

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The current real estate market presents a huge opportunity – and you need to have it on your radar. Have you ever heard the term “preferred equity”?

It's part of the real estate capital stack — or how all the money in a deal is stacked — and can be a smart way to bridge the gap in commercial real estate investing. If you haven't gotten into passive real estate investing yet, now is the time.

But wait…isn't justice the same thing? Before I got into passive income through real estate, I certainly thought so. I quickly realized that common stocks are different from preferred stocks and that investing in the latter could give me higher ROI and other benefits more quickly.

Of course, “preferred equity” may not be the most exciting topic of conversation. But I write with great energy today because I have the big picture in mind. I know that with an investment opportunity like this, I can create passive income streams outside of medicine that will allow me to live a life on my own terms and give me the financial freedom I dream of.

But first, let's clarify what preferred equity actually is, because it can be confusing. It is a form of ownership of a company or transaction that typically gives shareholders priority over common shareholders in receiving dividends and proceeds from asset sales.

For example, let's say a real estate deal involves a senior loan, preferred equity investors, and common equity investors. In this situation, the preferred investors in terms of who gets their money fall right between the senior loan guys and the common equity guys. When the property is sold, the senior loan is paid off first, then the preferred equity partners are paid, with the sale almost guaranteed to cover their return.

Unlike common stock, preferred stock often offers fixed or variable rate dividends that are similar to the characteristics of equity and debt securities. Today we'll look at the benefits of choosing preferred stocks for commercial real estate investing and how to get started.

In all of this, one thing must not be forgotten: preferred equity is still equity. And it can actually be a quicker way to get a higher return, especially if you know how to use it for commercial real estate. But be careful and proceed with due diligence.

Steady income

Preferred stock investors generally seek a balance between steady income and capital preservation. It's like a Goldilocks situation: not too cold, not too warm. Preferred shareholders have a lower risk profile compared to ordinary shareholders, but carry higher risk than debtors. For this reason, preferred stocks tend to have projected returns – medium risk for medium return. With fixed returns, it offers investors predictable income streams.

Why are projected returns a good thing? Preferred stock investments typically require shorter time frames to complete the deal, allowing for faster investment completion and maximum capital gains. You can make money and put that money back into a new investment. Additionally, regular distributions from preferred stock investments provide investors with steady income streams and improve and diversify portfolio stability.

You also have the option to set a time frame for your returns. For example, the so-called “current” preferred capital is set up to pay you every month or every quarter. This is good for people who want to create a steady cash flow. On the other hand, there is also “accrued” preferred capital, which means payments accumulate on paper but are sent out later. These deferred trades could be useful for higher returns (at higher risk) for tax purposes.

Choosing your desired mix of preferred stock investments depends on your portfolio, risk tolerance and investment preferences.

Cash flow

This class of stocks is abundant in the market today due to high interest rates. With interest rates high, sponsors and operators are getting creative with financing to raise capital. That means this is the perfect opportunity to get into a type of real estate – commercial real estate – that typically has a high entry point.

Personally, when an opportunity like this arises for me, I like to invest a portion of my portfolio in preferred stocks because they are a major drain on cash flow. Sure, the returns are limited most of the time, but it provides a little more predictability when it comes to money coming in.

Educate yourself: Start by learning about investing in preferred equity real estate, including its benefits, risks, and how it fits into your overall investment strategy. Join communities of like-minded people, like ours here at Passive Income MD, to begin your education.

Research opportunities: Explore various real estate investment opportunities with preferred equity structures, taking into account factors such as location, property type and investment conditions.
Evaluate risk and return: Evaluate the risk-reward profile of preferred equity investments, taking into account factors such as fixed returns, capital appreciation potential and the financial strength of the underlying real estate projects.
Network and build relationships: Connect with real estate developers, sponsors and investment platforms that specialize in preferred equity deals to capitalize on opportunities, learn how to ask the right questions and gain insight into market trends. Join groups like Passive Real Estate Academy, where like-minded people search for deals together.

Do due diligence: Conduct thorough due diligence on potential investments, including analyzing financial documents, evaluating property fundamentals, and evaluating the sponsor or developer's track record. If you need help with this, reach out to your team of experts, such as your accountant and financial advisor. Just because a sponsor promises big returns doesn't mean it will happen.

Invest and monitor: Once you have selected preferred equity investments that meet your goals and risk tolerance, invest capital and actively monitor the performance of your investments over time.

Diversify your portfolio: Consider diversifying your favorite stock investments across different properties, locations and sponsors to reduce risk and optimize overall portfolio performance.

Stay informed: Stay abreast of market trends, regulatory changes and economic indicators that may impact the performance of your favorite stock investments and adjust your strategy accordingly.

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Why wait any longer? Keep searching and learn how to create your ideal life through different income streams. Take action today to find the preferred real estate investment opportunities that will bring you closer to financial freedom and living your life on your own terms.

We here at Passive Income MD want to support you on this journey. So get in touch with us in one of our many communities, at our events and conferences or at the Passive Real Estate Academy. Wherever we next see you, we look forward to working with you, learning with you, and working together to find life-changing preferred stock deals. Until then, stay inspired and continue to challenge yourself to grow as an investor.

Peter Kim, MD, is the founder of Passive Income MD, creator of the Passive Real Estate Academy, and offers weekly training through his Monday podcast, the Passive Income MD Podcast. Join our community in the Passive Income Doc Facebook Group.