Understanding Preferred Return

We all know that real estate is the most powerful driver of wealth in the world, but it isn’t nearly as easy as picking a stock. Successfully investing in real estate requires knowledge, time and relationships with the right team members.

Because of this, many people lack sufficient real estate exposure in their portfolio– and as such, miss out on the fantastic cash flow, tax benefits and outsized returns it offers.

The great news is that you can still participate in real estate without having to acquire and manage your own real estate empire, and in many cases, do it with less risk and more diversification– by investing in real estate syndications.

Syndication is a structure in which a group of professions (the general partner) raises private capital from individuals (the limited partners) to fund the purchase of a real estate asset. The investors typically get paid first, then the general partner takes a minority share of the remaining profits for doing all the work.

The way these profits flow to all parties is called the “Waterfall”.

A Preferred Return (or pref) is typically the first hurdle in this waterfall. The pref is the minimum rate of return a limited partner will receive before the general partner is able to keep any profit for themselves. In other words, before the general partner can retain any profit, all profits must first be used to satisfy the limited partner a fixed percentage of their investment as a preferred return. For example, if the preferred return is 10% and a limited partner invested $50,000, the limited partner must be paid $5,000 before any profit can be kept by the general partner.

Let’s unpack the waterfall structure on a run-of-the-mill syndication deal:

7% Preferred Return

70/30 Split

This waterfall states that investors must be satisfied with a 7% return on their money before the general partner receives anything. To say it another way, it’s a 100/zero split, with 100% of the proceeds going to the investors (limited partners), until a 7% return on investment has been met.– after which proceeds will be split according to the next hurdle of the waterfall. In this case, a 70/30 split, with 70% going to the limited partners and 30% to the general partner.  

Here is another example of how a waterfall return might be paid using actual numbers:

Assume you invested $100,000 in a syndicated offering with an 8% preferred return, and an 80/20 split. For simplicity, let’s say the investment is sold exactly one year later, and generates a $100,000 profit.

1.  First, you, the investor (or limited partner) would receive a preferred return of $8,000 (8% of their $100,000 investment).

2.  Next, the remaining profit of $92,000 would be split between the LP and GP according to the predetermined split of 80% to the limited partners and 20% to the general partner. This would result in the following returns:

• Limited Partner - $81,600 ($8,000 preferred return + $73,600 upside split)

• General Partner - $18,400

Structuring returns using this waterfall method, particularly with a preferred return to the investors as the first hurdle, incentivizes a general partner to make the property profitable as quickly as possible. Because the quicker a preferred return is paid, the quicker the general partner can begin sharing the profit.

What happens if the preferred return is not met during the first few years?

The single-year example above is nice for simplicity, however most deals project a 5 year hold time– with small amounts of cash flow in the first few years until the property is improved and stabilized.

Let’s say you invested 100k in a deal with a 7% preferred return, with the following cash flow projection:

• 3% Year 1

• 5% Year 2

• 7% Year 3

• 9% Year 4

• 10% Year 5 + Sale. (Upon selling the asset, you’d also receive your initial 100k back, plus an additional approximately 40-80% return)

So while the preferred return is 7%, in Year 1 you only received 3% in passive cash flow. This deficit is not lost. It’s accrued, in what’s called “preferred return accrual”, or “pref accrual”. Even though (as expected) the project didn’t produce enough cash flow to meet the preferred return, the general partner still must honor the remaining preferred return owed from Year 1 before moving on to the next hurdle in the waterfall— the 70/30 split where they actually begin to make money.

In Year 2, cash flow is better, but still well below the 7% preferred return. Again, it’s not lost, it just adds to your preferred return accrual— the amount that must be paid to 100% to investors before the general partner begins sharing in the spoils.

An astute investor may ask, “does my unpaid, accrued preferred return balance compound?”. The answer is no, most of the time. Typically, unpaid preferred return accrues, but it does not compound.

Finally, in year 3, the pref is finally met, however there is still an additional 6% that must be backfilled before the GP is in the money. (4% from Y1 and 2% from Y2).

As you can see, in some cases it may not be until the deal goes full cycle (completes the business plan and sells) that the preferred return is met and exceeded. But you can rest assured that the sponsor is going to do everything they can to increase rents, decrease expenses and drive cash returns to investors to clear that hurdle as soon as possible. Because the faster they hit the investors pref, the faster they start making money.

While great for education, these examples are a bit oversimplified. In reality, preferred return is calculated on a daily basis by looking back to when the investor’s capital was placed, or to the preferred return start date, and is accomplished using an advanced Excel model, or by an investor portal software system like ours.

In either case, a preferred return is a powerful incentive alignment tool which ensures a general partner will work as hard as possible to squeeze juice for their investors. Because until the limited partners have received passive cash flow equal to at least the preferred return, the GP is essentially working for free.