What is Preferred Return in Real Estate?

Preferred returns, also called a pref, prioritize payments to limited partners in real estate syndications. Consequently, knowing the ins and outs of preferred returns is crucial for evaluating investment opportunities. In this article, we’ll teach you everything you need to know about a preferred return in real estate.

OnBridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income.

What is a Preferred Return?

A preferred return is one element of the payout structure in many real estate syndication investment deals. It designates which investors receive profits first and in what amount based on their capital contributions.

Usually, preferred returns structure a real estate deal first to pay the limited partners who made the capital investment. This provision gives investors a bit of a safeguard in that if the project makes money, they will be the first to receive it. 

The pref also tends to return money to the capital investors toward the beginning of the project. This acts as a selling point for some would-be investors, given that they are tying up large sums of money in the project.

Limited partners also like to see a preferred return, because it ensures that the capital investors are paid before the sponsor. When they only receive distributions after the limited partners, sponsors should be motivated to continue work to create a profit to enjoy their own share. For that reason, the pref is sometimes called the preferred return hurdle. 

How to Calculate a Preferred Return

The project contract will delineate the terms of the entire payout structure, including the preferred return. The pref is expressed as a percentage, often 6 to 8 percent. 

A pref of 8 percent means that investors designated by the pref receive 8 percent of their capital contribution from the first positive cash flow. So, for example, if an investor provides a capital investment of $100,000, and the project’s cash flow is $25,000, then the investor receives $8,000 anually. The remaining $17,000 would be allocated among other investors as determined in the agreement. Remember, the preferred return is just one of many terms dictating the allocation of profits.

The period at which the first cash flow is calculated and the payments will also be clarified in the syndication documents. For example, the cash flow may be calculated annually with preferred returns paid within 60 days. On the other hand, some syndications calculate cash flow quarterly, allowing for smaller, more frequent payments to limited partners.

The Role of Preferred Returns in Distribution Schemes

The preferred return is just one piece of the puzzle in the overall profit distribution plan for a real estate project. Knowing how it fits is crucial to understanding what an individual investor stands to gain after providing capital. 

Preferred returns are a common first step in a waterfall payout structure. Waterfall payout structures create multiple tiers of returns to the different classes of investors. Upon reaching one benchmark, the payout structure moves on to the next level.

Investors may encounter additional provisions that modify the terms of the pref. The other terms will further delineate who is paid and when.   

Preferred Equity Investment

In a capital event, preferred equity investors receive both a percentage of their capital investment back plus a specific rate of return on that capital before the sponsor gets a promotion. Typical capital events are the sale or refinance of real estate.

Catch-Up Provisions

A preferred return can be accompanied by a catch-up provision that turns the emphasis to the general partners’ returns. Catch-up provisions direct all returns above the pref to the general partners until a certain threshold is met. 

Non-Cumulative Preferred Returns 

While preferred returns give limited partners increased certainty regarding payment, some projects do not generate enough income during a distribution period to create enough profit to satisfy the pref of all investors entitled to it. 

Some syndications consider preferred returns non-cumulative, meaning that if there is insufficient cash flow to pay them during a certain distribution period, they will not be made up in the future. 

Lookback Provisions

Syndications with lookback provisions take a step to protect the preferred return of limited partners. At the end of any given return period, the general partner will relinquish a portion of their returns if the project failed to obtain a set return. The part they yield then goes toward the limited partners’ pref.

Final Thoughts

When considering real estate syndication as a source of passive income, pay close attention to the syndication’s preferred return terms. This small item in the syndication documents determines when limited partners earn distributions and how much those early payments are—so be sure you understand the terms before signing onto a deal!

OnBridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income.