What is a Preferred Return in real estate? The explanation may surprise you. There are many types of preferred returns, and it's essential to understand the difference between them to make an educated determination about your investment strategy. For example, there is a true preferred return vs. pari passu (even) preferred return - one offers more protection than the other for investors against losses on their investment property.
One of the primary appeals to investing in a real estate syndication is the prospect of passive income without having to shoulder the responsibilities of property ownership and administration daily. But, of course, few investments are ever genuinely secure. As a result, there is some danger associated with investing in a real estate syndication, although it may be reduced by investing in syndications that offer a higher return.
A preferred return ensures that investors profit before the sponsor (i.e., the syndicator) receives cash dividends.
In this post, we examine what investors should know about guaranteed rates.
Preferred Return Profit Distribution
Every real estate fund or syndication has a "distribution waterfall" to describe how different tiers of investors will be paid back, when, and for how much. In addition, most arrangements have some leveraging or bank debt. Before equity investors receive a return on their investment, debt is generally repaid first with interest before interest on the principal is paid out.
Preferred returns are the earnings that are then returned to investors before the syndicator makes any distribution. In other words, the phrase "preferred return" implies that investors have priority when distributions are made. As a result, investors receive 100% of the profits distributed until a preferred return barrier is breached.
If no profits are generated and shared, there is nothing for investors to receive. For example, if the preferred return is set at 8%, but there isn't enough cash flow to make an 8% distribution, investors may only receive less than that (or nothing) until the property begins generating cash flow. Preferred returns aren't always guaranteed; it's a widespread misconception among real estate investors.
Preferred Return vs. Equity Return
Preferred return and preferred equity are two distinct concepts. Preferred equity is a term used to describe a particular position in the capital structure, 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 an inevitable 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.
Preferred stockholders are entitled to a preferred return, but the timing and rate of that return might differ.
True vs. Pari Passu Preferred Return
Preferred returns might be structured in a variety of ways. For example, investors will receive a "pref" on their co-investment before the sponsor earns any distribution in a preferred return scenario. Some syndications, on the other hand, are structured with a "pari passu" preferred return. “Pari passu” is latin for “equal footing” and is also used relatively speaking within estate planning. Here, the pref serves as a threshold up to which investors and sponsors earn an equal distribution; returns above that point are unequally shared in favor of the sponsor who is then said to be earning a "promote," i.e., a disproportionate share of the profits in exchange for achieving or exceeding return expectations.
How Preferred Returns Are Structured
Preferred returns are often constructed with a "hurdle" rate, which must be surpassed in a specific capital distribution scenario. For example, a preferred return hurdle of 6% means investors must achieve a 6% return on their investment before any other money flow occurs. Return hurdles might vary from 5 to 12 percent, but they generally fall between 6 and 8 percent. Before the deal is offered to investors for consideration, the return hurdle rate is always determined.
Preferred returns can also be made up of a single payment or several payments over time. A return is cumulative if it's calculated as a sum from previous years' revenue. In cases where there isn't enough cash flow to reach the hurdle rate in one year, investors will be paid the remainder in future years as additional cash flow becomes available. When it comes to performance, investors should expect rates of return in the 10% range for any deal with an 8% hurdle rate. For example, if there is only enough cash flow to pay back 6% one year and you have a non-cumulative preferred return, the value of your pref does not build up over time even if the barrier rate isn't met.
When compound interest is used, the calculation is even more complicated. If the former, the interest will increase with time and create fluctuating interest payments.
Preferred returns may also be structured with a "lookback" or "catchup" provision.
A lookback provision, often known as a "clawback," refers to a clause that stipulates that if the limited partners do not achieve their agreed-upon return rate after disposition, the general partner (i.e., the sponsor) must give back a portion of the cash flow previously sent to them. One of the main reasons for a GP to fulfill – and perhaps exceed – syndication return expectations is owing to this lookback provision.
On the other hand, a catchup provision ensures that limited partner investors will receive 100% of the deal's cash flow until an agreed-upon rate of return is achieved (a "real" preferred return). After they've reached that rate of return, all funds will go to the general partner. Thus, the catchup provision works similarly to a lookback provision in that it helps guarantee that the LPs get at least their intended return on investment.
How Preferred Returns Work
The preferred return is the order in which partners are repaid their equity investment, as well as their share of the profits until a certain threshold has been achieved. This may be referred to simply as "the pref." For example, if an investor puts $500,000 into syndication with a 6% pref and one yearly dividend, they will get the first $30,000 before the syndicator receives any share of the profits.
Let's assume that the project's desired return has decreased to 8%, but the asset pays out distributions at 12.5%. The sponsor has now surpassed the intended return of 8%, and in this case, after investors are paid the 8% preferred return, there is a 4.5% remainder. Thus, for a 75/25 payout split deal, 75 percent of any extra money goes to investors and 25 percent to sponsors.
Why Is a Preferred Return Important?
There are several reasons why preferred returns are so important. First and foremost, offering a preferred return is one method to encourage people to put substantial amounts of money into a real estate syndication. The preferred return provides some optimism that investors will be repaid at least something, especially when the preferred return is cumulative and compounded over time.
A sponsor's preferred return is another method to align the interests of the sponsor and investors. The actual preferred return structure necessitates that the sponsor makes certain cash flow distributions before collecting anything. This helps to encourage sponsors to not only fulfill but also exceed investment goals. The sooner they start getting profits of their own, the more diligent they will be with company plan implementation.
The Takeaway on Preferred Returns
Although no real estate investment is ever guaranteed, one-way investors can safeguard their funds is to join syndication that offers a simple preferred return structure. This way, investors may rest assured that they will be repaid as soon as feasible and before the sponsor makes the transaction profits.
Investors will always want to read the private placement memorandum accompanying any deal opportunity to know how the equity waterfall is structured. These legal documents will shed light on what kind of pref you can expect, the hurdle rates that must be surpassed, profit splits, and whether the deal includes catchup or lookback provisions. In addition, all parties involved in the equity waterfall must align interests so that everyone benefits.