What Is a Preferred Return?

What Is a Preferred Return?

 

As an investor, you’ll run across the word “preferred” in multiple asset classes. One example is a preferred stock, which is a hybrid of an equity investment with distinct debt characteristics. Investors in a preferred stock receive their fixed distributions prior to common stock shareholders—and while common stock shareholders have more potential upside, the preferred stock shareholder gets preference in repayment if things go south. There is a clear tradeoff between the total potential reward that a common stock shareholder enjoys and the perceived safety of having priority of repayment.

In private real estate deals, the concept of preferred equity is similar but often misunderstood by investors, especially those who are new or inexperienced in the asset class. A syndication—which is another name for pooling together investor capital to purchase something larger as a whole rather than individually—is the most common private equity real estate deal. The deal is usually broken down to a general partner (the operator) and limited partners (the investors). Because the arrangement typically involves the limited partners contributing the majority of the investment funds needed for the purchase of the property, there is a need to align the operator’s sweat equity and the investors’ best interests.

That alignment comes in the form of a preferred return. The preferred return is a preference given to one class of equity before another class of equity in regard to the distribution of profits. In real estate syndications, the preferred return is given to the investor class of equity. The preferred return usually is benchmarked to a certain rate of return; once that rate of return is reached, the distribution of profits reverts back to align with the equity percentage each partner holds.

Today, the most common equity split is 70% to the limited partners (investor class) and 30% to the general partner (operator). You may see one or two standard deviations above or below those numbers, such as a 60%/40% split or 80%/20% split, but the norm is around 70%/ 30%. What this means is that after the preferred return hurdle is reached, every dollar of profit that is distributed from that point forward is subject to that split. This is why a preferred return goes such a long way toward establishing a minimum level of return because up to the preferred rate, the investor class receives 100% of the profits. You might ask, “Well, then how does the operator make his money?”, and the answer is that there are fees associated with purchasing and operating an apartment building. The fees range from a one-time acquisition fee of 1–3% of the total purchase price to an ongoing asset management fee of 1–2% of a based metric, usually capital or revenue. Most of the time, these fees are there to provide minimum compensation; the real profit comes when the preferred return hurdle is reached, and the operator becomes entitled to their split on any profit.

This is why operators are naturally incentivized to hit the preferred returns as soon as possible. They also don’t want to fall too far behind because it creates a bigger hurdle for them to overcome before they realize their profits.

Is a Preferred Return a Guaranteed Payment?

 

This is probably the biggest source of confusion for investors when they step outside of Wall Street investments—and the answer is no. When investing in traditional assets like stocks and bonds, the yield payments (either interest payments or dividend distributions) are expected to continue as stated. Sure, sometimes the economic landscape forces management in public companies to abruptly discontinue dividends, but for the most part, the expectation is for the investor to receive their full dividend payment that is declared by management. Public companies that have a reputation of paying dividends go to the ends of the Earth to maintain that distribution. This was something that I found puzzling when I would see publicly traded companies borrowing money in order to maintain their dividend distributions. The companies would issue statements justifying the borrowing as financially arbitraging lower yields from the bond markets, but at the end of the day, that debt would stay on the company’s balance sheet.

So if a company is willing to take on debt in order to pay its shareholders their stated dividends, it’s no surprise that investors would feel like those payments are guaranteed to them. In reality, nothing is guaranteed—just ask the shareholders of GM, GE, and the multiple other blue-chip stocks that saw their “guaranteed” payment get cut.

In private equity, the preferred return is not a dividend; instead, it is a hurdle that the general partner needs to clear before they participate in the profit splits, so it incentivizes them to perform with a sense of urgency.

While in some cases the preferred return is actually paid out during the year, most of the time it’s not. For example, an investor can invest in a single property or put their money into a fund that invests in multiple properties. Either way, the single property and the fund are self-contained entities that have to be capable of distributing profits without placing the investment in harm’s way. This occurred during COVID-19, when operators paused distributions. In many of those circumstances, the investment was still performing well, but the operator did not want to risk paying out a distribution and then getting a wave of tenants not paying their rent, resulting in the operator not being able to meet the debt obligations of the property. As an investor, you rely on the operator to only pay out the distributions when it’s fiscally wise to do so because the preferred returns, in many cases, are only a percentage of total returns. Above all else, the operator’s main role is to maximize total returns—not just pay preferred returns.

What Happens When You Don’t Receive Your Preferred Returns?

 

As an investor, it’s important to understand that there are two types of preferred returns: cumulative and non-cumulative. A cumulative preferred return will continue to roll over until the deal is sold. Here’s an example of what that may look like:

An investor invests $100,000 into a deal that pays a 7% preferred return, or $7,000, per year. In Year 1, the operator pays $4,000, rolling over a balance of $3,000 into Year 2. That means the investor needs to receive $10,000 ($7,000 from Year 2 and $3,000 from Year 1) before the preferred return threshold is met. It’s not unusual for certain syndications to roll over a balance right into the sale of the property. The profits from the sale are then redistributed with priority given to catching up on any missed preferred distributions. This is commonly referred to as the “catch-up provision,” and it can occur at any time in order to ensure the investors are fully caught up prior to the operator splitting the profit.

In a non-cumulative preferred return, the preferred returns do not roll over to the following year. In our previous example, the obligation for the operator to pay the $3,000 in Year 2 no longer exists. As an investor and fund operator, I’m not sure why any investor would agree to a non-cumulative preferred return unless they don’t know any better. In general, you should probably stay away from an operator who offers such terms. In my experience, the overwhelming majority of today’s syndications have a cumulative preferred return.

How Are Preferred Returns Calculated?

 

Preferred returns for an entire syndication can be calculated by multiplying the equity from the investor class by the preferred rate. For example, if $1 million is raised from investors to purchase a property, and the preferred rate is 6%, the annual preferred return would be $60,000. This number can also be broken down to an individual investor level. For example, in the same deal, if someone invested $100,000, the investor’s annual return is $6,000.

When it comes to the preferred return calculation, every investor needs to pay attention to how the distributions are made. In some cases, operators label them as a return of capital instead of a preferred distribution. The significance of the return of capital is that it lowers the preferred obligation for the deal in the subsequent year. In our example, instead of the operator paying $60,000 as preferred returns, the operator labels the distributions as a return of capital. This means in Year 2, $940,000 in equity is subjected to the preferred return hurdle. Some operators argue that this strategy is more tax friendly since the IRS can’t tax you for receiving back your own investment. The investment does start incurring tax liabilities when all of your capital is returned, but by then the preferred return hurdle is completely removed. One investment that came across my desk had an uncharacteristic double-digit preferred return, which stuck out right away. When I dug into the numbers, the operators clearly indicated in the offering that they intended on using the return of capital strategy, and they marketed the strategy as a big advantage to potential investors. Once I saw that, it made sense how they intended to pay such a high preferred return—they didn’t! In my opinion, real estate syndications have built-in tax shelters, such as depreciation, that make a return of capital distribution labeling completely unnecessary.

To be fair, a return of capital strategy can work in two scenarios:


1) The return of capital is not tied to a preferred return but rather a contractual rate based on the original investment. This allows the investor to benefit from the tax deferment but not have the payment obligation lowered in future years.


2) Additional money is paid back to the investors above the preferred rate of return. In some cases, the operator’s business model is predicated on increasing the value of a building during a short time period allowing for a capitalization event, such as a refinance, that returns a significant amount of capital back to the investor. This allows the investor to reinvest in other deals but keep the same amount of equity in the previous deal. However, the return of capital lowers the preferred return obligation, but in this situation, it’s actually a positive because the investor can invest in a second deal with the same amount of capital as he had in only one deal.

Here’s an example:

Investor A invests $100,000 in a deal where there is a 6% preferred return.

Year 1 — The investor collects $5,000, which leaves a preferred arrears balance of $1,000. The operator receives 0% of the profit since the preferred return was not met.
Year 2 — The investor collects $7,000, with a preferred balance of $0. The operator receives 0% of the profit since the investor was caught up from his arrears.
Year 3 — On January 1, the value of the property has doubled, and they are able to refinance out all of the original investor’s capital; $100,000 is returned to the investor. Any additional profits are split according to the equity ownership going forward.

Since the investor has all of their money back, they can invest in another deal but retain ownership in the prior investment until it’s eventually sold. The cash flow will be reduced because of the additional mortgage and the loss of the preferred return, but since there is no investor capital left in the deal, the returns to investors in the deal become infinite going forward.

The Importance of the Cash on Cash (COC) Metric

 

In most cases, investors look at preferred returns to determine what they will actually receive from their investment on an annual basis. However, the preferred return is not the correct metric to do so. Instead, the COC% is what an investor needs to pay attention to. This is what the operator thinks you will earn from your capital investment on a year-to-year basis. Since it’s common for the COC% to be lower than the preferred return the first few years of the deal, the importance of the relationship between these two metrics can’t be overstated.

A Final Word


As an investor, you should be mindful that some operators, especially those who are new to the space, use bait-and-switch techniques to “stretch” a deal to make it look more appealing. But in my experience, most syndicators, especially experienced ones, do the right thing and structure deals to have both a cumulative preferred return—and they only consider returns above the preferred return as a return of capital. What’s important is that you understand the business model that you’re investing in so you don’t get blinded by a good-looking preferred return, which may never materialize.

 

If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my bookThe Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways

Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.

 

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