Understanding Preferred Equity

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June 22, 2023

by a searcher in Houston, TX, USA

Newbie here!

I would like to understand how preferred equity works.

Situation: An investor invests $1,000,000 preferred equity with 10% preferred return over a 5 year term.

Do I pay off $1,000,000 with the 10% preferred return every year e.g $200,000 per year plus interest in year 1, and then the balance plus interest every year, or do I pay the preferred interest of the balance every year and make a balloon payment at the end of year 5?

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Reply by a professional
from Dartmouth College in Los Angeles, CA, USA
The term "preferred" refers to the preference in payment, meaning that the preferred holder will be repaid, along with accrued interest, before the common holders receive anything (though sometimes regular distributions can be paid pro rata amongst common and preferred, with the preference taking effect at liquidation or sale). Interest can accrue each year or be repaid, it depends on whether the company is making regular distributions, and can also be cumulative or non-cumulative.
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Reply by a searcher
from Boston College in Boston, MA, USA
Like Brian was saying, "preferred" means preference. Bonds/debt have the high payment preference, then preferred stock, and finally common equity. Preferred stock is pretty much the standard because of its payment preference & in the event of bankruptcy preferred stock takes priority over common stockholders.
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