Somebody drew preferred equity as a set of stairs on a placemat for me
I'm land and long holds and I don't do any of this, but I ended up at a small dinner where two people spent forty minutes arguing about pref equity and I finally admitted I didn't know what they were talking about.
One of them turned over the paper placemat and drew stairs. Bottom step, the bank with the mortgage, gets paid first, has a lien on the building. Top step, the sponsor, the person doing the work, gets paid last and gets the upside. Middle step, preferred equity, gets paid after the bank and before the sponsor.
Then she said the part that made it click. The middle step doesn't own a claim on the building. It owns a piece of the company that owns the building, with a written agreement that says it gets paid before the sponsor does. So it looks like a loan from the sponsor's side and it is technically equity.
I asked why anyone would do it instead of just a bigger mortgage and the other guy at the table said because the bank won't lend that much anymore. Loans coming due were written when rates were lower, the new loan is smaller, and someone has to fill the difference.
I still don't fully see how you get paid if it goes badly, since you don't have the lien. But the stairs helped.