What is a Preferred Return? How Do They Work?
Living in a capitalistic society here in America fortunately for us this allows for the opportunity to create large sums of capital gains in varying rates of time.
This means that we could earn $2,000 dollars for a week of work, $2,000 dollars for an hour of work, or even become $2,000 richer without even working at all.
This exposes the opportunity in front of each of us: passive investing, in more specific terms, passive investing in multifamily commercial real estate.
Many individuals who choose to passively invest in multifamily syndications will earn money passively without having to trade their time for money.
As passive investors they will receive a return on their investment over a period of time without having to spend any man-hours to achieve substantial returns.
Sound nice? Not having to trade your time for money? On top of that wouldn’t it be nice to comfortably sit at the front of the line to receive the first payout, too?
This is what’s known as a preferred return.
Preferred returns provide passive investors the opportunity to receive the first distributions of revenue generated from an investment property first, before any of the syndicators get a penny.
This essentially puts them at the front of the line when it comes to payday. Reason number one to why the preferred return is preferred.
Preferred Return’s in Multifamily Syndications
If you’re reading this article, you’re probably currently investing in real estate or you are looking to learn more about real estate investing.
Understanding preferred returns is key to putting yourself in the best position to achieve the highest returns from your real estate investments as possible.
In the case of multifamily real estate syndications, a preferred return is paid to investors who invest their own capital to assist in the buying of the multifamily complex.
These are classified as class “A” shares.
In most cases, preferred returns are determined by a percentage ranging from 5-12% but the most common preferred return percentage will land around 6-8%.
The preferred return is established before the deal is presented to potential investors.
Once the deal is in action, the predetermined percentage of the preferred return must be paid out to investors (Owners of “class A” shares) before the sponsorship team can collect any revenue.
With this structure, the person offering the deal to investors, also known as the deal sponsor is incentivized to make the property produce as much money as possible, otherwise, money will be missing from their own pockets since the preferred return must be paid to the deals investors first.
This builds confidence for investors to believe in the sponsor’s deal and fuels the sponsor to explode profits to be as high as possible.
The last point to mention, which again benefits investors, is the fact that preferred interest is typically accrued.
This means that if the sponsor ever hits a month where the expenses are unusually high (usually during rehab on the property) and the full preferred return is not distributed to investors, then the percentage of the deficit is accrued, and rolls over to the next year.
In this scenario, the investor would receive all the distributions, the sponsor would receive none, and the deficit would accrue and then be paid out on top of the distributions for the following cycle.
Why a Preferred Return is, in fact, “Preferred” as an Investor
As one can see from how a preferred return is structured, this favors the investor in times when the economy may take a downturn.
When the economy hits a recession, or if the property is going through a period with unusually high expenses and does not have the ability to pay the full preferred return, the investor has a bit of a safety net.
If there’s ever a time that investors of class A shares are not paid the full percentage of their preferred return, investors will accrue the deficit of that percentage and will be paid first in line for the following year plus the previous year’s deficit carried over.
This structure is the prime example of why a preferred return is actually preferred among many investors and provides them a level of safety and confidence within their investment.
Preferred Return Example’s
In most deals, preferred returns primarily range anywhere from 6-8%, depending upon the quality of the sponsor and the area you’re investing in.
With an 8% preferred return, as explained above this structure would distribute 8% of distributions to be paid to investors and any distributions above the 8% preferred return would follow a split or waterfall structure outlined by the initial terms of the deal!
A deal is outlined by the operating agreement and as an investor it’s important that you read this document very closely and ensure you understand all splits and fees associated with the investment offering.
Splits can take place in a variety of ways. Let’s give the common example of a 75/25 split. With a 75/25 split this would mean that after the 8% preferred return has been paid out to investors the remainder of the preferred return would be split 75% to investors and 25% to the deal sponsor.
In the efforts to break this topic down further please examine the two examples below.
Example #1: With an 8% preferred return and distributions are paying out at 7%, the sponsor did not hit the 8% preferred return. There is a deficit of 1%, this percentage is accrued, and must be paid out to investors the following year. Meaning in year 2 of the investment project, the investor will receive the usual 8% preferred return along with the 1% from year one, totaling a 9% return, before the sponsor can receive any returns. From this example, we can see why a deal sponsor must be highly motivated to ensure the performance of the asset, above the investors preferred return.
Example #2: Let’s say that the project’s preferred return is still 8% but the asset is paying out distributions at 14%. The sponsor has now exceeded the preferred return of 8% and in this scenario, after the investors get paid the 8% preferred return there is now a 7% remainder after paying out the 8% preferred return. For a deal with a 75/25 split, 75% of any excess distributions go to the investor and only 25% will go to the sponsor.
Out of both examples given, the only scenario in which a deal sponsor gets paid is if they keep the asset performing at an optimal level.
This shows how important it is to the sponsor that the preferred return is a feasible number to achieve, otherwise it’s disadvantageous for the sponsor to promise that percentage.
This allows investors to find confidence in the preferred return.
As an investor, it’s important to find a sponsor that has a strong and consistent track record of paying out the preferred return.
Time to Make Your Money Work For You
What we see most often is that many people over-analyze, fall in love crunching numbers, and circling trying to find the “best” opportunities, and ultimately never take action to meet their goals.
I would almost dare to say losing a little money is better than never playing the game. You’ll learn from your lessons and make a profit on the next one.
Don’t sit on the sidelines forever. Get out there and start putting your money to work for you.
Understand how a preferred return works and find a deal sponsor that offers investors strong and realistic preferred returns.
Consider the strength of an investment where you invest $50,000 and there is a preferred 8% return annual ($4,000) every year delivered to your mailbox, and that’s at the bare minimum and not in the case if your sponsor exceeds that preferred return.
When you find a strong sponsor that offers you metrics in your favor, take action, and let the power of the preferred return work in your favor.