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What is a preferred return, and why does it matter in real estate investing? This article covers the “what” and “why” of preferred returns and the order in which stakeholders in real estate projects receive distributions. We’ll highlight the distinction between preferred equity and different types of preferred return, and how they play out with respect to distribution waterfalls.
Preferred Return Definition
A preferred return is a type of investment position that contractually guarantees payment priority, and/or returns to a certain threshold before other investors receive profits. Preferred return is a key concept in the structuring of real estate investments.
What is a Preferred Return in Real Estate?
As an accredited investor exploring commercial real estate (CRE) opportunities, you may have come across the term “preferred return” or “pref.” This concept is crucial to grasp when evaluating potential investments and aligning your financial goals with the right projects. In this article, we’ll dive into what preferred return means, how it works, its implications for investors, and key considerations when assessing investments with preferred returns.
Preferred return is a term used in private equity and real estate investing to describe the minimum return that investors must receive before the sponsor or general partner can participate in the profits of an investment. It is essentially a hurdle rate that must be met before the sponsor can earn their carried interest or “promote.”
For example, if an investment has an 8% preferred return and the property generates a 12% return, the investors would receive their 8% return first, and any excess profits would be split between the investors and the sponsor according to a pre-determined structure, such as 70/30 or 80/20.
Preferred returns can be structured as cumulative or non-cumulative. In a cumulative structure, if the preferred return is not met in a given year, it accumulates and must be paid out in future years before the sponsor can participate in profits. Non-cumulative structures do not carry over unmet preferred returns from previous years.
Preferred return refers to the order in which profits from a real estate project are distributed to investors. In other words, preferred return indicates a contractual entitlement to distributions of profit, relative to other investors. The priority of this distribution is maintained until a predetermined threshold rate of return has been met. Once met, profit distributions are made to any other subordinate stakeholders in the investment. The structure of this distribution waterfall varies from deal to deal (see examples below).
How Should Investors Look at the Preferred Return in Today’s Market?
The preferred return structure is important to understand at all times. Different market conditions may put additional emphasis on this factor of your real estate investment.
In 2024 economy is still broadly healthy and demand drivers remain strong for many asset classes, including multifamily. However, inflation remains sticky and may persist for some time. Hence, preferred return is at a premium to help insulate against volatility and bolster consistent cash flow.
At EquityMultiple we seek to structure investments that provide some degree of preferred return, whether as part of a preferred equity investment or as part of the structure of an LP equity investment.
This mechanism is critical to real estate investing because they provide a degree of predictability for investors, which can be a significant factor in attracting capital. If investors know they’ll receive a set return, regardless of the performance of the asset, it provides a level of comfort that can lead to increased investment activity.
— Tim Callahan, CEO of Callahan Capital Properties
How can you tell if you’re entitled to a preferred return? Be sure to look at the investor documents and make note of the distribution waterfall and what preferred return (if any) you may be entitled to. As we’ll discuss, there are also several different structures for preferred return in real estate investments. Be sure to identify the type of preferred return you may be entitled to.
Key Takeaways
- Preferred returns are a contractually obligated threshold of return that investors are entitled to before other positions in the investment are paid.
- Preferred returns may apply to both preferred equity and common equity positions.
- There are different arrangements for preferred equity, as we’ll cover.
One key nuance to keep in mind for passive investors in real estate transactions: preferred returns do not guarantee that distributions will happen on a particular timeline. Preferred return establishes, contractually, the order in which investors receive distributions; the extent and timing of those distributions will depend primarily on cash flow from the property.
Preferred return in real estate investing is part and parcel of who gets paid, when, and in what order. Investors whose position entitles a preferred return typically have priority, at least within the tranche of capital they sit within. This ordering of distributions is often rule-based and can get complicated.
Break Into CRE with a nice rundown of waterfalls in real estate equity investments, a key component of preferred return dynamics.
Is Preferred Return the Same as Preferred Equity?
Preferred Return and Preferred Equity are different concepts that are often closely related. Preferred equity refers to a specific position in the capital stack, senior to common equity and subordinate to debt.
Preferred Equity gets paid out before Common Equity and is priced at a certain percentage return, called a preferred return. That return can be paid current out of cash flow, accrue, and be paid upon a sale, or a combo of both.
Upon repayment of preferred equity, the remaining cash flow goes to common equity partners (through a distribution waterfall). Often, the first two tiers of the distribution waterfall are 1) the return of principal and 2) a different preferred return up to a threshold rate of return (8%, for example). These two tiers can be interchangeable, depending on the investment’s Operating Agreement. Generally, both the GP, or “sponsor,” and the LP (EquityMultiple and its investors) will receive a return of capital upon sale of the property, all other cash flow will go toward the preferred return, and then a portion of the remaining profits until both the GP and LP get to the 8% return threshold.
Preferred equity investments always entail a preferred return. A preferred return hurdle may also be in play for common equity investments.
Preferred returns can provide a solid foundation for real estate investment partnerships. By setting clear expectations around returns, investors and sponsors can align their interests and focus on executing the investment strategy rather than worrying about the financial structure of the partnership.
— Jonathan Needell, MD at Kairos Investment Management
Different Arrangements of Preferred Return: Real World Examples
“Pref” can be structured in several ways. Distribution waterfalls can be confusing. Let’s take a look at the main ways preferred returns may be structured and examples of how profits would be distributed in each.
Preferred Equity
This arrangement corresponds to a position in the capital stack and typically entitles an investor to both their return of capital (principal) and a fixed-rate return before any capital is returned to the sponsor and other equity investors.
An earlier EquityMultiple investment, Captiva Club Apartments, serves as a straightforward example of a preferred equity investment. Each EquityMultiple investor is entitled to a non-compounding 13%* annual return for three years, after the senior debt is paid, and before the Sponsor receives any cash returns.
Preferred equity is a compelling structure of real estate investment for many individual investors because of the hybrid return model. Preferred returns are typically contractually obligated to investors, making it more of fixed-income proposition than equity real estate investments. Because it is subordinate to debt positions, preferred equity generally offers higher rates and total return, often including a “kicker” or accrued return at exit.
EquityMultiple Director of Investor Relations Daniel Brereton gives a rundown of how preferred equity works.
Common Equity – True Preferred Return
In this arrangement, the LP investor will receive a preferred return before any capital is returned to the sponsor; the investor will receive profits up to a predefined percentage rate of return.
Let’s look at our Bushwick Mixed-Use Redevelopment Project. The order of profit distribution is as follows:
- 100% pro rata to investors (including the Sponsor and LPs) until they have received a cumulative 10% preferred return
- Return of investor capital contributions, pro rata
- 30% to the sponsor and 70% to investors (including the Sponsor, such that the Sponsor receives a share of the 70% in addition to their 30%
Pari Passu Pref.
In Latin, “Pari Passu” means “on equal footing”. In this arrangement, the sponsor and the investor are treated equally up until the rate of return threshold is met for each. After this threshold is met, the sponsor’s promotion will kick in for all remaining profit distribution.
Let’s look at our College Station, TX Student Housing Acquisition Project. The order of profit distribution is as follows:
- 100% pro rata to investors and the Sponsor until all have received an average 8% annual return across the term of the project
- 100% pro rata to investors until all capital contributions have been returned.
- Thereafter, a straight 65% to investors and the sponsor pro rata, and 35% wholly to the Sponsor.
“Investors want to see a clear path to achieving their desired returns, and preferred returns can help provide that clarity. By establishing a preferred return, investors can have confidence that their investment will generate a predictable stream of income, even if the property does not perform as expected.” – Spencer Levy, Chairman of Americas Research and Senior Economic Advisor at CBRE.
What is a “good” preferred return? It depends a bit on context. As with any financing instrument, capital markets function to calibrate terms of engagement between GP and LP investors. With most equity investments, as of 2023, EquityMultiple typically works to build in an 8% preferred return threshold for investors (as you see in the example above). Note, however, that preferred returns in equity investments shouldn’t be weighed directly against those from a preferred equity investment. Preferred equity investments definitionally entitle investors to payment before LP equity positions.
Preferred Return — The Bottom Line
While the distribution waterfall for any given project may be fairly opaque at first glance, keeping these concepts in mind will help you identify the payment structure. For any offering where “pref” comes into play, the specific terms will be laid out in investor documents.
Our Investor Relations Team is always available to answer questions to ensure that you have a clear picture. Feel free to reach out — ir@equitymultiple.com