Understanding Preferred Returns

Welcome to our in-depth guide on Preferred Returns - the most commonly misunderstood term by newer investors in commercial real estate.
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You'll learn:

  • What preferred returns are
  • Why preferred returns exist
  • Worked example of preferred returns
  • Types of preferred returns
  • How preferred returns protect your investment

What are Preferred Returns?

Preferred returns play a critical role in bridging trust and safeguarding smaller investors interests.

Real estate syndications are a rapidly growing investment strategy where multiple investors pool their capital to invest in bigger, higher quality projects.

A Sponsor or General Partner (GP) leads the investment and actively manages the project, while smaller investors or Limited Partners (LPs) invest passively in the project.

A Preferred Return is used by GPs to provide LPs a base level of investment returns, before GPs start sharing in the upside.

What is a Preferred Return?

A preferred return is a profit distribution preference whereby profits, either from operations, sale or a refinance, are distributed to one class of equity before another, until a defined rate of return is achieved on the initial investment.  

The 'pref' is stated as a percentage, such as an 8% cumulative return on initial investment.

Preferred Returns help align GP and LP incentives

In real estate syndications, Preferred Returns are designed to balance protection for investors while offering sponsor upside.

Protection for Investors

  • Preferred return is essentially a safety net for investors

  • Ensures investors are first in line to receive profits up to a predetermined percentage

Incentivizing Sponsors and Syndicators

  • Offers sponsors and syndicators the potential for structured upside

  • This aligns the interests of the management team with those of the investors, as it incentivizes the sponsors to maximize performance

Influence of Economic Cycles

  • Preferred return rates may vary through economic cycles and different risk profiles of projects

  • During a down market, a sponsor may need to set a higher preferred return to attract investor capital

Investors should expect 5% - 10% Preferred Returns when investing in private real estate

Determining the right Preferred Return number for a specific investment involves many factors including sponsor experience, submarket and the underlying project. For LP investors, understanding how it works and its influence on incentives is most important.

Know how your investment sits in the Capital Stack

Preferred Returns commonly appear in both Preferred Equity and Common Equity.

Debt

  • The most-senior position, usually consisting of the mortgage or loan used to acquire the property

Mezzanine Financing

  • A hybrid form of financing that sits between debt and preferred equity

  • Usually structured as debt but can be converted into equity.

Preferred Equity

  • A position in the capital stack that has repayment priority over common equity but is subordinate to debt

Common Equity

  • The GP and LP interests, which are subordinated to both debt and preferred equity

  • This is the most common investment path in syndications and should have preferred returns as part of its deal terms

Is Preferred Return the same as Preferred Equity?

No - they are very different. Unfortunately, some investors get mixed up between how they work.

Preferred Returns = Profit Distribution

Preferred returns and preferred equity are distinct concepts within the realm of real estate investments. While both involve preferences in terms of capital returns, they are very different.

Preferred returns pertain to the order in which profits are distributed among equity holders. Is is the priority of profit distributions based on the class of investment. Investors with preferred returns receive their initial investment back plus set percentage return before profit share.

Preferred returns primarily focus on the distribution of profits among equity holders.

Preferred Equity = Position in Capital Stack

Preferred equity refers to a specific layer or position in the capital stack, which has a higher repayment priority compared to common equity but is subordinate to debt.

Preferred equity investors not only receive their initial investment back but also a preferred return on their investment before common equity holders receive any distributions.

In summary, preferred returns establish the order of profit distributions among equity holders, while preferred equity designates a specific position in the capital structure that prioritizes the return of capital.

Preferred Return is just one of the terms you'll see

There are many inter-related concepts in assessing financial returns in real estate syndications.

Cash Flow

The amount of actual cash flow generated by the property.

Cash-on-Cash Return

The percentage of cash flow received relative to the initial equity investment.

Preferred Return

The prioritized distribution allocated to the equity before another until a specified rate is achieved.

Accrued Preferred Return

The cumulative dollar amount that would be owed to the investor.

Promote

The profit-share the sponsor receives once the preferred return has been met.
The dollar amount of Preferred Return will change over the life of the investment

As Preferred Return is calculated on the outstanding equity balance, the dollar amount will change over the life of the investment.

This is because the outstanding equity balance will be paid down by distributions from the project, meaning the Preferred Return is being calculated on a 'lower base' of outstanding equity.

Most syndications have a cumulative and compounding preferred return, meaning if the Preferred Return is not paid - it compounds on itself.

How it works in practice?

The model below shows how a $100,000 equity investment would evolve over time as the preferred return compounds and as distributions are made to the investor. 

You can create a copy of this model here.

Understanding the change in Outstanding Equity and Sponsor Promote.

In most syndications, only once the preferred return has been repaid and all the outstanding capital returned to investors, then sponsors can start sharing in the promote. For example, once investors receive a Preferred Return of 8% and all outstanding equity back, sponsors receive 20% of the upside (the "promote").

The Ending Equity Value shows how much of the preferred return is still owed to the investor after accounting for cash distributions so far. The negative values from Year 3 indicate that the cash distributions are now surpassing the preferred returns, reducing the outstanding equity value (but importantly, not the investors ownership in the project). 

Once all outstanding equity to investors has been repaid, preferred return no longer accumulates and returns are then shared with the Sponsor as per the waterfall split (for example 70% to the investors, 30% to the Sponsor).

True Preferred Returns vs Pari-Passu

Beware, in the world of private real estate syndications, not all preferred returns are created equal.

True Preferred Returns

A True Preferred Return means that the investor gets priority when it comes to profit distributions. The investors receive their preferred return before the sponsor receives any profits.

Example: Imagine an investment that has an 8% true preferred return. If the investment generates $10,000 in profits, investors would first receive $800 (8% of their investment), and only then would the sponsor receive any share of the remaining profits.

Pari-Passu Preferred Returns

On the other hand, Pari-Passu Preferred Returns mean that investors and sponsors are on an equal footing regarding the preferred return, up until a certain threshold when the sponsor receives a promote.

Example: Using the same scenario with an 8% preferred return and $10,000 in profits, but this time with a pari-passu preferred return, both the investor and the sponsor would each receive $800 simultaneously up to 8%, with additional profit being part of the promote split.

Why Sponsors choose different types?

The choice by the investment sponsor between true preferred and pari-passu preferred returns can depend on various factors.

Risk Profile

In riskier investments, investors might demand a true preferred return as a form of protection while in lower-risk investments, investors might be more willing to accept pari-passu returns.

Sponsor’s Track Record

Experienced sponsors with a solid track record might be able to negotiate pari-passu returns, as investors have more confidence in their ability to generate profits.

Negotiating Power

Large investors or those who are contributing a significant portion of the capital might be able to negotiate for true preferred returns.
Investors should focus on two things

1. Ensure Incentives Aligned: Understanding these distinctions and the reasons behind a sponsors choice is essential in evaluating the terms of an investment. You want to make sure the incentives are aligned with your investment goals and risk tolerance.

2. Recognize Potential Red Flags: If a real estate syndication does not include a preferred return, it is important for investors to ask why? The absence of a preferred return may indicate a higher risk or a lack of alignment, which should prompt further investigation.

Take the first step in growing your wealth

You now understand preferred returns and their role in investment strategy.

We hope this knowledge helps you make more informed and confident decisions.

Interested in viewing pre-vetted investments with leading sponsors across the US?