What is a Preferred Return?
One of our newer investors, Bill, left me a voicemail yesterday.
“Hey, uhh, Paul, I’ve got a question on my distribution. Can you call me?”
I knew what exactly what Bill wanted to discuss. If I didn’t care about Bill personally, I could have copied and pasted another email to reply to him before he asked his question. Of course, I didn’t do that.
I called Bill back after lunch, and it was precisely as I had predicted.
“Hey Paul, I got my first distribution. Something was bothering me about it, so I calculated it...and it seems short of what I expected. I was thinking it would be based on my 9% annual preferred return. But it looks closer to 6% annualized.”
A common misconception...and perhaps a misnomer
What is a Preferred Return and How is it Different from an Actual Return on Investment?
In short, it’s a private equity term used to describe the priority of cash flow within a deal structure. It’s an important term for passive real estate investors to understand.
Equity Multiple states...
“At a basic level, preferred return refers to the ordering in which profits from a real estate project are distributed to investors. Preferred return means contractual entitlement to distributions of profit (from net cash flow) until a threshold rate of return has been met, before profit distributions are made to any other subordinate stakeholders in the project.”
Crowdstreet explains it a bit differently:
“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”...”
So when we review these definitions, we realize that a preferred return is not really a return on investment at all. The preferred return is a hurdle. It is a threshold. It is the level where the profit share between the investor and the sponsor begins.
Up to the cumulative preferred return level, investors receive 100% of the distributable cash flow from the investment. Above this level the sponsor shares in the profit split.
The distributable cash flow is the gross revenues of the profit less all expenses, debt service, and fees.
If the preferred return is cumulative it means that the investor will receive the first X% (the preferred return) for that year as well as a make-up for prior years’ shortfalls (the preferred return minus the actual return).
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Why is the Preferred Return Important for Investors?
The sponsor obviously knows a lot more about the details of a prospective deal than investors do. And the sponsor has authority over the activities (property management, etc.) that will cause the project to perform according to its predicted outcomes.
Investors are trusting the sponsor to accurately project these numbers and to follow through to see them come to pass. So the preferred return is a gesture on the part of the sponsor to show his or her confidence in the projected outcomes.
Why?
Because after management fees and other operational costs, the sponsor is offering investors 100% of the distributable cash returns up to the level of the preferred return hurdle. If the project returns at or below this cumulative level, the sponsor will receive zero profit share in the project. This zero includes cash generated from operations as well as cash generated from refinancing and appreciation from the sale of the asset.
And no sane sponsor would do that much work to end up with zero. So the sponsor is motivated to project well and to operate well. And to refinance and sell well.
It is important to note that offering a preferred return does not necessarily mean there is an alignment of interest with the sponsor and investor. The sponsor benefits if the project does well, but the investor takes the risk if it doesn’t. This can incentivize risk-taking on the sponsor side. The sponsor can offset this risk by putting their own cash into the project. We make sure the operators we invest with put substantial amounts of their own cash into their projects. In addition, we as Wellings Capital principals invest our own money into the deals.
An Example of Preferred Return
Net of all fees and splits, let’s say a fund projects 8% average annual cash-on-cash distributions and a 15% total annual return over approximately 10 years. So an investor who invests $100,000 would receive $250,000 (their $100,000 principal plus $150,000 in total profit) back in a decade.
Let’s say this same fund offers a 9% cumulative preferred return to investors, then an 80/20 split with investors receiving 80%, and the sponsor receiving 20%.
How much should investors expect to receive and how would the cumulative preferred return factor into these calculations?
If distributable cash flow is 5% in year one, investors will receive all 5% and bank 4% (9% preferred minus 5% actual) toward a future distribution.
If distributable cash flow is 7% in year two, investors will receive all 7% and bank 2% more (9% preferred minus 7% actual) toward a future distribution.
If distributable cash flow is 8% in year three, investors will receive all 8% and bank 1% more (9% preferred minus 1% actual) toward a future distribution.
In year four, assume the fund refinances and sells several assets which creates a distributable cash flow of 18%. Investors would receive the first 9% since that is the annual preferred return level. But years one through three left a cumulative make-up of 7% (4% + 2% + 1%). So the investors would get the next 7% of the distributable cash in that year.
Above that level there would be an 80/20 split. So with the 18% cash flow minus the 16% paid to investors, there would be 2% left for the 80/20 profit share. The first 1.6% (80% of 2%) would go to investors. The remaining 0.4% (20% of 2%) would go to the sponsor.
In year five, assume the distributable cash flow is 15%. In that case, the first 9% would go to the investors and the remaining 6% would be split 80/20.
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Caveats and Exceptions
Please note that this example doesn’t take into account the potential dwindling principal in some scenarios. The outstanding principal is the basis for the preferred return calculation, and if the principal is reduced through payments above the preferred level, then the preferred return would be calculated as a percentage of this new number. Most (perhaps all) syndications are set up this way.
Note that this example also does not take into account a non-cumulative preferred return. Some syndications only do a preferred return for the current year of cash flow distributions, which means there is no make-up.
Also note that some syndicators have a catch-up provision. This means that after investors receive their preferred returns, all returns above that level are paid to the syndicator first has caught up to a pre-determined level. In this case, the split on the total deal might be determined to be 80/20 for example. So after the investors receive the preferred return, the syndicators get paid all of the distributions above that level until the total split is 80/20.
It is important to read the PPM and ask the sponsor for clarity on these terms to be sure you understand everything, before going down the road of investing. Many sponsors don’t care or want their investors to understand these things because their investors would realize what’s actually happening within the deal structure.
Clear as Mud?
Does this all make sense? I hope this short post helps clear up any confusion about the often-misunderstood concept of preferred return. If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call.
Real estate investments and securities offerings are speculative and involve substantial risks. Please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.
