What Is a Preferred Return In Regards To Real Estate Investing?

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

The “pref” is stated as a percentage, such as an 8% cumulative return on initial investment; however it can also be stated as a certain equity multiple.  This preference provides some comfort to investors since it subordinates the sponsor’s profits participation or “promote” up to a certain return threshold.

Here are a couple easy examples to understand:

1) Venture Debt Fund: I'm currently invested in a venture debt fund that charge 2% of assets under management and 20% of profits (carry). The venture debt fund has an 8% preferred return, meaning the 20% carry of profits won't kick in until after the fund returns at least 8%. The 8% covers the 2% management fee e.g. a 8% preferred return after 2% management fee.

1) Crowdfunding Fund: Real estate crowdfunding is one of my favorite investments because it allows for easy access to high quality, lower valued, higher yielding properties around the country that were once unavailable to the general public. I've invested in RealtyShares Domestic Marketplace Equity fund that chooses the best deals off its platform. Its preferred return is 8% and its target IRR is 15%.

To the extent the Fund receives distributions from its underlying investments, the distributions are first split pro rata (based on capital contributions) between Fund investors to pay investors their accrued preferred returns until all investors have been paid their full accrued preferred returns.

If the Fund's initial distributions are not enough to pay investors' their full accrued preferred return, investors will still continue to accrue the preferred return, which will then be paid out of the next available distribution. The Fund intends to make monthly distributions for the its preferred equity investments and quarterly distributions for its JV equity investments.

These distributions are not net of the Fund's annual asset management fee of 0.85%. The fees will be netted out of distributions at the end of the year.

The following are more complicated variations of preferred returns written by CrowdStreet, another real estate crowdfunding platform. Crowdstreet is unique in that it has a direct-to-sponsor platform which allows investors to gain more transparency and communicate directly with the sponsors.

I like CrowdStreet because it focuses on 18-hour cities where valuations are cheaper and cap rates and growth rates are higher. Here's my comprehensive review.

Preferred Return v. Preferred Equity

The preferred return is distinct from the idea of “preferred equity,” which is a position in the capital stack that has a repayment priority. The difference lies in the return on and return of capital.  The preferred return is a preference in the returns on capital, while a preferred equity position is one that receives a preference in the return of capital.

In most true preferred equity investments, investors get their initial investment and also get a set percentage return on their investment before the subordinate equity investor gets even $1 dollar of cash flow. If the investor does not receive a return of capital before the sponsor or some other equity tranche, then the investor is in a “common” or “JV equity” position and not a preferred equity position.

The True v. Pari Passu Preferred Return

An investor in a common equity position can still receive a pref, and the type of pref can be further distinguished based on the treatment of sponsor capital, called the co-investment.

If the investor receives a preferred return (i.e. profits) before a sponsor does, then the pref is a “true” preferred return; however, if the investor and the sponsor receive the same preferred return, paid at the same time, then pref is a “pari-passu preferred return.”

With a true pref, the investor receives preferential treatment on its capital contribution; with a pari-passu pref, the investor does not.  Instead, the pari-passu pref acts as a threshold up to which investor and sponsor capital are treated equally and over which the sponsor capital receives a promote..

To help clarify these concepts, consider the following examples.  The returns in these examples are not necessarily indicative of prevailing market rates.

Related: What Is Mezzanine Financing And How Does It Work?

Preferred Equity

In this example of preferred equity, the investors first receive their capital contributions plus a 10% annualized return before then sponsor receives any money.  Second, the sponsor receives its capital contribution.  Finally, investors receive 20% of all excess profits with the sponsor receiving 80% of all excess profits.

The investors receive a true preferred return rate and, in exchange, they receive only 20% of profits over their 10% true preferred return.  Overall, the return is likely to be lower than if they participated in the upside in a JV equity position; however, their overall investment risk is lower.

Common Equity with a True Pref

In this example of a common equity investment with a true pref, the investors receive a 6% annualized return before then sponsor receives any money.  The difference is that the sponsor receives a return of capital pro rata with the investors.

Above the 6% investor pref, investors and sponsor divide excess profits 60% / 40% respectively .  The investors likely receive a lower pref, in comparison to a pari-passu pref, because it is a true pref.

Common Equity with a Pari-Passu Pref

In this example of a common equity investment with a pari-passu pref, the investors and sponsor each receive an 8% annualized return on their investments and return of capital, pro rata.

Above the 8% pari-passu pref, investors and sponsor divide excess profits 75% / 25% respectively.  In this case, investors do not receive any profits before the sponsor does.

The pari-passu pref allows the sponsor to receive cash flow alongside the investors during the investment period. The investors’ repayment risk is higher, but they also share in more of the profits.

In this scenario, the investors are treated as equal to the sponsor until the pref is paid and capital is returned. Beyond that point, the sponsor earns a disproportionate share of additional profits via its promote.

Simple v. Cumulative Pref

The final item of note is that the pref is not always calculated in the same way.  Sometimes, the sponsor calculates the pref on a simple interest basis.  The alternative is a compounding basis.  S

upposed that an investor is entitled to a 10% annual pref, but that in the first year, there is only enough profit to pay a 5% return. In the second year, cash flow ramps substantially and pays a 15% return. In the simple interest basis, the additional 5% would still be owed next year but not added to the initial balance.

In the compounding basis, the outstanding 5% would be added to the investor’s capital account for purposes of calculating the next years preferred return. This example is shown below.

Non-compounding

Compounding

Notice in the compounding example, even the ramped up 15% return did not satisfy the accumulated return owed.  It fell short by $500, which would then be compounded into the pref accrued for Year 3. Over time, the compounded pref can generate substantially greater returns in the case of operating shortfalls in earlier years.

Recommendation

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