This month we share a guest post from one of my partners, Dan Handford:

What is a Preferred Return?

A preferred return is a minimum return that you would receive before the operator would receive any of their share of the cash flow or sale proceeds.

It is typically expressed as a percentage of return on an annual basis. For example, if you invested $100,000 and the preferred return was 7% then you would receive $100,000 x 0.07 =  $7,000 in annual return if available from the cash flows.

The preferred return is vital to you as a passive investor when investing in multifamily assets. It will allow for a better alignment of interest between you and the operator. This is because the internal rate of return is one of the main metrics that you can use to evaluate the performance of your investments. The operator will be focused on the time value of money to reduce the overall lifespan of the investments to increase your overall return.

The main reason for an operator to not offer the preferred return is that it does not delay their split of the profits and this is a huge misalignment of interest with the passive investor. In addition, if they do not offer a preferred return, then they are likely not well-capitalized and need the proceeds from the cash flows to fund their syndication operations.

Cumulative vs Non-Cumulative

When reviewing a private placement memorandum (PPM), you will want to make sure that you receive a cumulative preferred return to protect your overall return.

In a non-cumulative preferred return, if you do not receive your preferred return one year, then you lose it. Every year the preferred return resets and does not carry forward.

A cumulative preferred return allows for you to add a lagging return one year to roll over to the next year. For example, if your preferred return were 7% and you only received 6% one year then your preferred return the following year would increase to 8% (7% + 1% = 8%).

In a cumulative preferred return, as the cash flows increase year-over-year from the asset you would begin to be made whole on the preferred return. The preferred would be caught up when you sell the asset if it still did not have the cash flows to make it up.

As you can see, you want to read your documents carefully to make sure that you are investing in projects with a cumulative preferred return. All our investment offerings have this feature so there is nothing to worry here with us.

True Preferred Return

In a true preferred return (also known as “hard preferred return”), the operator only receives a portion of the profits from the cash flows or sale proceeds after you (the passive investor) receive your entire preferred return. This would be considered the first hurdle in the waterfall distribution schedule.

Preferred Return with Operator Catchup

For a preferred return with catchup, once the preferred return is achieved the operator receives all or most of the profits until the operator catches up to the equity split amount to what you (the passive investor) already received from distributions. This type of catchup provision allows the operator to receive its entire equity split as originally agreed by you. This type of hurdle is common in the real estate syndication space. The catchup would be considered the second position in the waterfall distribution schedule.

Preferred Return vs Preferred Equity

A preferred return relates to receiving a priority treatment as it relates to the return on your initial capital invested.

In preferred equity you would be in a priority position in the capital stack to receive your returns during the hold period and in a priority position to receive your initial capital back first when the asset is sold.

It is a good idea to diversify your investments in a portion of preferred equity positions to low the risk profile of your overall portfolio. The risk is reduced since the preferred equity positions in the capital stack are typically only 20-40% of the overall equity portion of the capital stack. As a preferred equity investor, you would receive your specified return and your initial capital back before any of the other investors.

Situations When the Preferred Return Goes Away

The preferred return is calculated based on what is called the unreturned capital contribution. This is typically the initial capital that you have invested in a project. However, there are scenarios where your preferred returns can be reduced or eliminated completely.

The actual returns that you are receive each month could be reducing your unreturned capital contribution depending on how the operator structures your returns. These can either be classified as return of capital or distributions from profits.

If your returns are calculated as return of initial capital, then your unreturned capital contribution amount would be reduced each time you received a payment. Some operators will say that this is a good idea, so you are not actually paying taxes on the cash flows. However, the problem with this for you as the investor, is that your preferred returns are based off the unreturned capital contributions, so your preferred return is starting to be diminished. This is great for the operator as it allows them to achieve profitability faster since they will be able to hit their equity hurdles since the preferred return is going down. This is not a good idea for you as the investor. You also do not have to worry about the taxes right now anyway since the depreciation each year should offset all the distributions you receive anyway.

The standard process for reducing your unreturned capital contributions is by a capital event such as a refinance or supplemental loan. When one of these events occur, you would receive a portion of your initial capital back and this amount would reduce your unreturned capital contributions.

For example, if you had originally invested $100,000 into an offering and in year three there was a refinance and you received $40,000 from the refinance then your new unreturned capital contribution would now be $60,000. All your preferred return calculations would be based off the new $60,000 balance and not the original $100,000.

With this example, it is important to note that even though your unreturned capital contribution was reduced, this does not reduce your equity position in the overall deal. This amount is only used to calculate your preferred returns. However, there are operators that will reduce your equity position during a refinance or supplement loan so be very diligent in reading the PPMs to make sure you know exactly what you are getting yourself into from the start.

Final Thoughts

The preferred return is a powerful tool for us to show preferential treatment to you and to provide a deep alignment of interest with you as one of our passive investors. Allowing preferred returns reduces the overall risk when investing in one of our offerings since you will receive the first proceeds of all cash flows.

Our offerings also provide cumulative preferred returns to make sure you receive the returns first even if not achieved one year.

Depending on the potential strength of an offering, we have done some offerings with a catchup provision and some with no catchup.

Finally, our offerings do not reduce your unreturned capital contributions when receiving regular monthly distributions. This allows you to maintain consistent cash flows throughout the investment life cycle.

All these details are important to us as we want to have our investors continue to invest with us for many decades and not just one or two deals. This is the main reason why we go above and beyond to protect our investors returns and their invested capital.

In an upcoming article, we will go into more detail on equity waterfalls and hurdles so you can have a better understanding on how this impacts your returns and why it is so important to understand.