What Is A Preferred Return In Real Estate Investing?
If you’re a doctor or other busy professional, you may be looking for ways to invest money to secure your financial future. You may have heard that alternative investments such as a real estate investment is a good option, and that’s true – but it’s important to understand the different types of metrics in order to determine the best properties to invest in.
And one of those metrics is the preferred return.
In this article, we’ll look at:
- general information about a preferred return
- how to calculate it
- the pros and cons
- an example to bring everything together
Let’s get going…
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What Is a Preferred Return In Real Estate Investing?
Every real estate syndication or private equity fund has a “waterfall structure” which describes how, when, and to whom funds are paid.
I don’t know about you, but before I put money in an investment offering, I want these questions answered up front as well.
To learn more about the distribution waterfall structure, check out this video:
Most syndication deals (including the ones I’m in), use bank debt for leverage. Typically, before any limited partners (passive real estate investors) receive a return on their investment, debt is repaid first with interest before interest on the principal is paid out.
The cash flow distributions that are returned to passive investors (you and me) before the general partners get paid is the preferred return.
When the limited partners have priority when distributions are made, this is an example of a preferred return.
As a result, they receive 100% of the profits until a preferred return hurdle is reached.
As you can imagine, having a structure like this incentivizes the sponsors to perform the best they can otherwise they don’t get paid. A sensible general partner typically won’t undertake a project if they don’t believe they can significantly outperform the preferred return.
For example, if the preferred return is 7%, but there’s only enough cash flow to make a 7% distribution, the sponsors don’t receive distributions until the property begins generating cash flow.
Preferred Return vs. Equity Return
Sometimes people confuse preferred return and equity return to mean the same thing, yet they are two distinct concepts.
Preferred equity is a term used to describe a particular position in the capital stack and typically entitles an investor to both their return of capital (principal) and a fixed-rate return before any capital is returned to the sponsor and other investors.
It’s usually subordinate to debt but before common stock.
Preferred equity is similar to holding Class A shares of stock. Before common shareholders receive any cash flow payments, preferred equity investors will generally earn their initial investment back as well as a certain percentage return on this investment.
The return on preferred equity may be paid out of current cash flow, build-up, paid out when the business is sold, or a combination of both.
True Preferred Return vs. Pari Passu Preferred Return
Preferred returns can be structured in a number of ways.
For example, in the “true pref” structure, passive investors will receive a preferred return up to a predefined percentage before any capital is returned to the sponsor.
On the other hand, if a syndication is structured with a “pari passu” (latin meaning “on equal footing”) arrangement, the sponsor and the investors are treated equally up until the rate of return threshold is met for each.
Once this is accomplished, any returns above this point are unequally shared in favor of the sponsor who is then said to be earning a “promote“. The sponsor promote refers to the share of profit paid to the general partner “promoter” in exchange for achieving or exceeding return expectations.
Do Preferred Returns Accrue?
Typically the preferred return interest in a real estate syndication accrues. If at anytime during the hold period an investor isn’t paid the full percentage of their preferred return, they’ll accrue the deficit of the pref percentage.
During the following year, they’ll be in line to be paid first plus the previous year’s deficit that’s carried over.
For example, many times during the first few months of acquiring a property that needs rehab, expenses can dramatically increase. If the sponsor is NOT able to distribute the preferred return to investors because of this, then the percentage of the pref deficit is accrued rolling over to the next year.
In this example:
- passive investors would receive all the distributions of profit
- the sponsor would NOT receive distributions
- the deficit would accrue and then be paid out on top of the distributions for the following cycle
This is why most passive investors prefer a preferred return due to the fact that it provides them a level of safety and confidence within their investment.
How Are Preferred Returns Structured?
Preferred returns are often constructed with a “hurdle” rate. This rate must be surpassed before sponsors are paid.
For example, a preferred return hurdle of 7% means the passive investors must achieve a 7% return before any other money flow occurs.
Return hurdles can range anywhere from 5-12%. Most of the syndications I’m currently in range from 6-9%.
The preferred return can also be structured as
- simple… or
Cumulative return structure
Passive investors get the benefit of compounding with a cumulative preferred return structure as it’s calculated as a sum from previous years’ revenue.
For instance, let’s assume you invest in a syndication deal that’s paying a 7% preferred return. Unfortunately in year one, there’s only enough cash flow to pay 4%, leaving a 3% deficit. In year 2, the asset earned 10%, which is just enough to cover the year-one deficit.
In a syndication with a cumulative pref, the missing 3% in the first year is added to the passive investor’s capital account. This actually increases the overall basis for calculating returns in year two.
In situations like this where there isn’t enough cash flow to reach the hurdle rate in the first year, investors will be paid the remainder in future years as additional cash flow becomes available.
In the example above, if there was a simple preferred return, the investor would get the full 7% in year two, plus the 3% owed from year one.
Preferred returns may also be structured with a “lookback or “catchup” provision.
If a syndication has a lookback provision, this means that if the limited partners do not achieve their agreed upon return rate after the sale of the asset, the sponsor must give back a portion of the cash flow previously sent to them.
One of the main reasons for a sponsor to do everything they can to bring value to a property in order to potentially exceed the return expectations is owing to this lookback provision.
On the other hand, a catchup provision ensures that limited partners will receive 100% of the deal’s cash flow until an agreed upon rate of return is achieved. After that rate is met, all funds will go to the general partner.
In theory, the catchup provision works the same as a lookback provision in that it helps guarantee that the limited partners get at least their intended return on investment.
An Example of a Preferred Return
Dr. S is tired of trading time treating patients for money and decides to take action. He’s educated himself on how passive investing in syndications can be used to replace his doctor income and has chosen to invest in a multifamily syndication fund.
He has $500k in a checking account to invest in this deal which pays a 6% preferred return. This means that he’ll be paid $30,000 ($500k x 6%) before the syndicator receives any share of the profits.
If this project pays out distributions at 10.5% the sponsor has now surpassed the intended return of 6%. In this situation, after investors are paid the 6% pref, there is a 4.5% remainder. Thus, for a 75/25 payout split deal, 75% of any extra money goes to investors and 25% to the sponsor.
The Bottom Line
Unfortunately, too many times I see new Passive Investors Circle members that try to over-analyze real estate deals trying to find the “best” opportunities keeping them grounded and never take action.
If you decide to always sit on the sidelines, then you’ll NEVER be in a position to start putting your money to work for you.
Once you have a basic understanding of how the syndication process works, then you’re ready to find a deal sponsor that offers investors strong and realistic preferred returns (or join the Passive Investors Circle) and work with those I invest with.
As a side note, if you have any specific questions regarding your tax situation, consult your tax advisor.Join the Passive Investors Circle