What is Preferred Return in Real Estate?
What is Preferred Return in Real Estate?
A preferred return is a type of investment that provides an investor with a predetermined rate of return. It is usually a set percentage of the invested capital.
You would receive a predetermined return before the operator of the investment would gain any of the income generated from the cash flow or the proceeds of the sale.
Generally, it is expressed in the form of a yearly percentage. To illustrate, if someone had $100,000 to invest and the expected return was 7%, then the yearly return would be 0.07 times the $100,000, which is equal to $7,000 from the money generated.
When investing in multifamily assets, the preferred return is a crucial factor for passive investors as it allows for a better connection of interests between the investor and the operator. This is due to the fact that the internal rate of return is one of the principal measurements for evaluating the performance of investments. The operator will be emphasizing the importance of the time value of money to reduce the overall duration of the investments and consequently, improve the overall return.
An operator’s lack of offering a preferred return comes down to the fact that doing so would slow down their sharing of the profits. This can cause a misalignment of interests between them and the passive investor. Furthermore, if they don’t present a preferred return, they may not have enough capital to finance their syndication operations, and thus need the cash flow to keep their process going.
Cumulative and Non-Cumulative
The former involves the gradual build-up of something over time, while the latter does not necessarily involve a gradual increase.
Analyzing a PPM should include making sure to gain a cumulative preferred return for the purpose of safeguarding your complete return.
For a non-cumulative preferred return, should you not be granted your desired return for the year, then it is relinquished. Each year the preferred return is restarted and does not accumulate.
A cumulative preferred return permits the addition of the prior year’s lagging return to the next year. For example, if the preferred return rate is 7% and the yield is only 6% for a given year, the preferred return rate for the following year would increase to 8% (7% + 1% = 8%).
As the cash flow from the asset increases, the cumulative preferred return starts to be fulfilled. Should the asset not have enough money to cover the preferred return by the time it is sold, it will be accounted for then.
It is essential to take the time to thoroughly read any documents when investing to guarantee a cumulative preferred return. All our investment offerings include this feature, so you can be certain that you can expect this from us.
Achieving the sought-after preferred return is a reality.
The operator only collects a piece of the revenue from the money generated or sale money after the passive investor has received the full preferred return, which is the very first hurdle in the waterfall distribution schedule.
Achievement of the desired outcome with the involvement of the responsible individual is what is generally referred to as “Operator Catchup”.
When the preferred return is reached, the operator gets the majority of any profits until they reach the equity split that was initially promised to you as the passive investor. This catchup clause is pretty common in real estate syndication. It is the second priority in the waterfall distribution.
The Difference Between Preferred Return and Preferred Equity
Gaining a preferential return indicates that you will be given priority when it comes to the yield on your original investment.
As a preferred equity investor, you would be among the first to receive returns during the investment period and to have your initial capital returned when the asset is sold.
In order to reduce the risk within a portfolio, diversification with preferred equity positions is recommended. This is because the equity portion of the capital stack is usually only 20-40%, meaning these investments will generally come before others. As a preferred equity investor, you will receive your established return and initial capital prior to anyone else.
In certain circumstances, the preferred rate of return may no longer be available.
What is referred to as unreturned capital contribution is generally the starting money you have committed to a venture. Nevertheless, on occasion, there are situations in which your preferred yields may be reduced or completely wiped out.
The amount of money you obtain every month could be lowering the amount of initial capital you have invested, contingent on how the manager has organized your returns. These can be viewed as a return of capital or proceeds from profits.
When your returns are measured in terms of the original capital investment, your unreturned capital contribution will decrease with each payment. Some operators may promote this as a way to avoid taxes on the cash flow. However, this could be detrimental for the investor since their desired returns are based on the unreturned capital contribution; thus, their expected returns will be lower. This is beneficial for the operator since it allows them to reach profitability earlier as they meet their equity goals more easily. But, this is not a desirable situation for the investor. Additionally, you don’t have to worry about the taxes since the annual depreciation should cover all the distributions you receive.
When a refinance or supplemental loan takes place, it can serve as a capital event to decrease the amount of unreturned capital contributions. As a result, you would be refunded a portion of your initial capital, thereby diminishing the amount of unreturned contributions.
If you initially put $100,000 into an offering, then in year three, when a refinance happened and you were given $40,000, the new unrefunded capital investment would be $60,000. Any preferred return estimations should be determined based on this $60,000 instead of the original $100,000.
It is worth emphasizing that while the unreturned capital contribution may be reduced, this does not affect your equity stake in the deal. This figure is only taken into account when computing your preferred returns. Nevertheless, there are instances when refinancing or borrowing extra money can reduce your equity stake, so it is critical to read the PPMs with care to be aware of what is being agreed to from the beginning.