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Everything you need to know about: Preferred Returns


If you've ever looked at a Multi-family real estate investment, you've probably heard: "This deal has an 8% pref." What does that mean? The common understanding is that a preferred return is some sort of a guarantee to the investor that they will receive a certain level of return every year. This is incredibly inaccurate. So what, exactly, is a preferred return and how does it work? When you finish this article, you'll understand what a preferred return is, what it is not, when to expect it and how to avoid some pitfalls that can come up in a deal with a preferred return.


Basic Definition

In a real estate deal, there is oftentimes a division of profit between the sponsor (the one running the deal) and the investors. A preferred return simply means that the investor receives something before the sponsor.


A preferred return simply means that the investor receives something before the sponsor.

Let's look at an example:

Investment amount: $100,000

Profit Split: 70% to investor. 30% to sponsor.

Year One profit: $10,000


Scenario One: 8% preferred return

Investor Profit: $9,400

Sponsor Profit: $600


Scenario Two: No preferred returns

Investor Profit: $7,000

Sponsor Profit: $3,000


Do you see what just happened? In the first scenario, the first 8% of the invested funds, or $8,000, was distributed to the investor. The remaining $2,000 was divided according to the agreed upon profit split, so the investor received another $1,400 (70% of $2,000) and the sponsor received $600 (30% of $2,000).


In the second scenario, there was no preferred return, so the division of profit begins at the first dollar of profit, and the full amount of $10,000 is divided between the investor and the sponsor 70/30.


Additional Profit

This is the basic definition of the preferred return, but there are several ways the additional profit (the profit not included in the preferred return) can be distributed.


The first way, is for all profit above the preferred return to be considered regular profit and split between the investors and the sponsor according to the agreed upon profit split (the promote). This is the division of profit employed in the earlier example.


Another option is that the profit is still fully returned to the investors.


In this case, the operating agreement will state that the promote is not realized until a capital event occurs.


In plain English: the sponsor will not receive his cut of the profit until the investors receive back a certain amount of their initial investment either in the form of a sale or refinance (more on this later).


Here you might wonder: so why bother with the preferred return? All the profit until the sale goes to the investor anyway?


Here you might wonder: so why bother with the preferred return? All the profit until the sale goes to the investor anyway?

Great question.


In this scenario, there are two possibilities as to why there would be a preferred return.



Deferred Preferred Return

The first of one is: Deferred Preferred Return


This is not an actual term, but it sums up the concept well. What happens if there's no profit in a deal for a year? Perhaps a major tenant broke their lease, or the building was purchased at 70% occupancy in order to capitalize on the upside of tenanting a building. Is the 8% from that year lost?

In this situation, the promote is not realized until the preferred return has been fully paid out. In simple terms: if any part of the preferred return was missed and not caught up in subsequent distributions, the missed preferred return amount is paid to the investors from the profit from sale before profit is split between the investor and the sponsor.


Let's walk through an example.


Let's say a deal has an 8% preferred return and a 70/30 promote (we keep using this because it's pretty standard). The initial equity contribution was $1,000,000 and now the property has been sold, all debts cleared and there are proceeds of $1,500,000 in the company account. How is this divided up?


If the preferred return had been already fully paid out, the investors will receive back their principal ($1,000,000) and an additional profit of $350,000 (70% of $500,000). The sponsor will receive $150,000.


If the sponsor had to suspend the distributions for two years, there would be $160,000 worth of preferred returns owed to the investors (8% per year, for 2 years). In this scenario, the investors will receive their principal ($1,000,000), their catch-up preferred return ($160,000) and then another $238,000 (70% of $340,000) and the sponsor will receive $100,000.


Thanks to the preferred return, the investors profited and additional $48,000.


As you can see, the preferred return creates a powerful incentive for the sponsor to make the payouts on time and protects the investors in the event that a payout is missed.


Reduction of Equity

The second application of the preferred return even when the distribution is allocated 100% to the investor is the opposite scenario: The cash distribution is greater than the preferred return.


In this scenario, distributable funds are greater than the preferred return and the sponsor has stipulated that any distribution greater than the preferred returned will be qualified as return of equity and reduce the equity position of the investor.


No, this doesn't mean that the sponsor can somehow take the building away from the investor. Let's walk through a case-study and see how this works.


Let's go back to our original deal: 8% preferred return. 70/30 promote.


What happens this time, however, is the investment property is generating 10% a year, after expenses. The full 10% is distributed to the investor. In this case, the first 8% is considered rental income from his property. The additional 2% is qualified as a return of the initial investment. The investor still receives 10%, but after it has been paid out, he is left with 98% equity in the building.


Why does this matter? Let's recall, the promote is only realized after the investor receives back his investment. We now have a situation in which the investor has recouped some of his initial investment. That 2% amount is now subject to the promote, which means that the cash flow of that 2% position will be split 70/30 between the investor and sponsor.


Now, practically, this is not how it, typically, plays out. Usually, the promote will not be realized one percent at a time. Rather, it will be triggered at a certain point.


This is usually done in one of two ways.


The first is it reduces the amount the investor receives pre-promote at the sale of the property.


How does this work?


Let's continue our current scenario: an investor invests $100,000 in a deal with an 8% preferred return and a 70/30 promote. The actual annual distribution is 10% which means that every year, the investor receives 8% as rental income and an additional 2% of his initial equity contribution (the investment) is returned. This continues for five years.


After five years, the building is sold and the net proceeds from the sale (after all taxes and debts are paid off) is $150,000.


How much does the investor receive before the split with the sponsor?


$100,000 (his initial equity contribution)?


Not quite.


In this scenario, the investor has already received $10,000 (2% a year for five years) as return of initial equity. He only has 90% of his initial equity "in the deal". As such, he will receive another $90,000 and the remaining $60,000 from the sale proceeds will be divided according to the promote.


The second scenario in which an early return of equity would be relevant is in the event of a refinance.

In some deals, a portion of the equity is returned, but the investors retain ownership of the building. This is accomplished through a refinancing of the property. This means that, due to an increase in the value of the property, the owners can borrow more against the property, thereby recouping their initial investment while retaining ownership of the property and the ensuing distributions.


It's important to understand how this works with the promote. Let's take a simple scenario:

Initial Equity: $1,000,000.

No preferred return.

Promote: 30% (to the sponsor)

Annual distribution: $100,000


This means that if the building were to be sold, after the initial equity contribution of $1,000,000 was returned to the investors, the rest of the sale proceeds would be divided 70/30 in favor of the investor. Until then, the investor receives $100,000 a year (10% cash-on-cash).


What happens if the building gains value and they refinance? Again, let's keep it simple. Let's assume they can refinance and receive an extra $1,000,000, and that raises the annual mortgage payments by $60,000. The investors will receive back 100% of the capital they initially invested.


Now pay attention, this is the important part: the building itself is now considered profit and subject to the promote. This means that the original owners retain ownership of 70% of the building and the sponsor receives 30% of the ownership or the building.


This is actually the exact same thing that happens at a sale, only in this case the profit is not proceeds from sale but the actual building.


So what happens with the distributions? Well, for starters, they are less, because we have all that extra debt to pay off. So the annual distribution starts at $40,000 ($100,000-$60,000). Only now, the investors will receive $28,000 from that (70%) because they no longer own the entire building. (In case you're feeling bad that the investor's return dropped from $100,000 a year to $28,000, remember that the $28,000 is after they have received back their full investment.)


This was a clean example. Often enough, a refinancing will result in partial payoffs. For example, if the refinance would have resulted in returning $800,000 (80%) to the investors, the investors would retain ownership of 76% of the building. They would own 70% of the 80% that was paid off (56%) and retain full ownership on the 20% portion.


Now that we understand how a refinance works, we can also understand another way a preferred return may be used. Any funds that were returned to the owners as return of principal, reduces the amount needed to be returned in order to trigger the promote.


For example, in the above scenario where the refinance accomplished an 80% return of capital, if the deal had an 8% preferred return and lasted for five years, the investors would have already received $100,000 as return of principal (10%). In turn, after the capital event (the refinance) they would have received 90% of their investment in return, and their ownership position would be 73% (90% x 70% = 63% + 10% = 73%) instead of 76%.


If all these numbers are a bit confusing, focus on the main principle at play: any equity returned to the investors as return of capital will reduce their share of ownership and result in them receiving less before the profit (whether it be ownership in the building or funds from the sale of the property) is split with the sponsor.


It's important to note that this is not done just to benefit the sponsor. Such a setup serves as an incentive to the sponsor to make quarterly distributions and exceed the promote, which benefits the investors as well.


Conclusion

In summation, we've reviewed the basics of what a preferred return is, and how it protects investors and serves to align investor and sponsor interests by guaranteeing either a payout throughout the life of a deal, or a larger "first cut" of the profit from sale. We also walked through two scenarios in which a preferred return may be used to cap the investors return as an ownership distribution and how such a setup incentivizes a sponsor to return capital faster.


A quick note: Always remember to check that this is spelled out in the operating agreement. A sponsor can advertise a preferred return, but the actual terms are determined by the operating agreement.


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