A preferred return in real estate, sometimes called an investment hurdle or first money out, is a way for capital investors in a deal to get paid first. A preferred return is a way to protect the capital of limited partners in a real estate deal, who often inject the majority of the money into a project.
This is building on typical joint venture agreements that are less complex, and it gives more certainty to money partners in a real estate syndication deal. After all, they are risking large sums of capital on your real estate deal.
For real estate investors, offering and understanding a preferred return can help attract more investors to deals and ultimately optimize deal and investor flow. Here's an overview of preferred returns, examples of how this works, and whether real estate investors should try to get in on the action.
What is a preferred return in real estate deals?
A preferred return in real estate is a way of structuring money flow to pay out funds to specific types of investors first -- typically the money/limited partners. For instance, let's take a look at a hypothetical real estate deal with an 8% pref, or preferred return. This means it would allocate 8% of capital invested from profits first to limited partners and then secondarily will allocate any remaining capital to other partners.
- Assumptions: One capital/limited partner, one operating partner, an 8% preferred return, $50,000 net cash flow, $100,000 capital contribution from the limited partner, and 50/50 split following that.
- Results: The preferred return would be $8,000 to that capital partner (8% of $100,000) as a preferred return.
- The remaining $42,000 would be distributed according to the capital flow structure -- in this case, 50/50 (or $21,000/$21,000) going to the general and limited partner.
How is a preferred return structured?
There are many considerations when implementing a preferred return, which can be structured in dozens of different ways. Here are some of the aspects of a preferred return that investors should be aware of as they consider this tactic.
Waterfalls: A preferred return is the first step in what is typically referred to as a waterfall capital structure. Simply put, waterfalls are a distribution structure that dictates how returns are paid out to various classes of investors in a real estate syndication deal. A preferred return may be the first part of a waterfall, but then there are many levels following that that require consideration as to how and when they flow to specific investors.
Preferred return hurdle: This refers to the specific amount that needs to be achieved in a given capital-out scenario. That is, a preferred return hurdle of 6% means that that return must be achieved before any other capital outflows can occur.
Preferred equity investment: Another variation of a preferred return is preferred equity. This simply means that a preferred equity investor will get a return of capital including a defined percentage return on their initial investment before any of the other investors receive funds following a capital event. A capital event is simply when capital is pulled out of a real estate investment, typically through a sale or refinance.
Cumulative or noncumulative pref: Preferred returns in real estate can be cumulative or noncumulative. That means if one year there isn't enough net cash flow to cover the preferred return (maybe due to deferred maintenance or a large capital cost), then the outstanding preferred return may or may not accumulate the following year. In this case, if only 4% was able to be paid out as a preferred return on an 8% pref, a cumulative scenario would dictate that during the following payment period, the preferred return would be 12% rather than 8%.
Compounding or simple interest: Preferred returns can get even more complex as you introduce compounding or simple interest rates. If you're using compounded interest rates as your preferred return structure, then you'll need to compound that interest over the desired period.
Lookback provision: This means that at the end of the established return period, a "look back" will occur and if a specific return has not been achieved, then the general partner will typically give up some of their returns to the capital/limited partners.
Catch-up provision: A preferred return with a catch-up provision means that the capital investor gets all the returns until a certain threshold is met, and then following that, all the returns go to the general partner until a certain threshold is met.
Pari passu preferred return: This is where both the capital and general partners are treated on equal footing until a specific return has been reached. After that, new capital flow rules will apply.
Preferred return in real estate calculation examples
Here are a few examples of how a preferred return in real estate works:
- Scenario: A non-compounding preferred return to two capital investors who each put in $100,000.
- Cash flow: $60,000 yearly.
- Distribution schedule:
- Pref: 8% preferred return to capital investors ($8,000 annually x2).
- 2nd: Return of capital (remaining funds all go to capital investors until they receive $100,000 each).
- 3rd: Remaining capital and equity distributions are split with 60% to investors and 40% to the general partners.
- Scenario: One capital investor puts in $200,000, and the general partner puts in $50,000.
- Cash flow: $75,000 yearly.
- Distribution schedule:
- Pref: 6% pari passu pref to capital investors ($12,000 to the one capital investor and $3,000 to the general partner).
- 2nd: Remaining net cash flow splits 50/50.
- 3rd: If an internal rate of return (IRR) of 15%+ is obtained by the general partner, then the capital flow changes from 50/50 to 70/30 favoring the general partner.
- Sale: Upon refinancing or sale, the first money out is a return of invested funds to the capital partner ($200,000), and then the remaining proceeds are split 50/50.
The bottom line on preferred returns
As you can see, there is no one industry standard when it comes to preferred returns in real estate. Investors can get very creative when structuring how capital flows from a particular real estate syndication deal.
A preferred return gives additional certainty to capital investors that they will receive a standard and guaranteed rate of return on their money, in addition to the other benefits of the real estate deal -- appreciation and mortgage paydown. This is why real estate investments are so lucrative and appealing to investors who want to participate passively in them. In the end, a preferred return arms active real estate investors with an additional tool to attract outside investors.