A common feature of a real estate equity waterfall, the concept of the  “preferred return” or “pref” can be particularly tricky for investors who are not familiar with its variations.  Not all prefs are calculated in the same way so it’s important for investors to understand the different types of prefs and how to distinguish these prefs from the “preferred equity” or “pref equity” position in the capital stack, which can often be conflated.

What is a Preferred Return?

When there are profits to be distributed, either from operations, sale, or refinance, one class of equity (and ergo the investors in that class) may get the benefit of cutting to the front of the line, so to speak, before another class until a certain rate of return on the initial investment is reached.  This preferential treatment is what’s referred to as the preferred return, or pref. The pref is stated as a percentage, such as an 8% cumulative return on initial investment; however, it can also be stated as a certain equity multiple.  This preference provides some comfort to investors since it requires the sponsor to wait until a certain threshold is met before they (the sponsor) are entitled to profits participation or “promote.”

Preferred Return v. Preferred Equity

Sometimes people use the terms “preferred return” and “preferred equity” synonymously, but they mean very different things.  “Preferred equity”refers to a position in the capital stack (the layers of debt and equity in the deal) that is entitled to a repayment priority.  The preferred return is a preference in the returns on capital, while a preferred equity position is one that receives a preference in the return of capital.  In most true preferred equity investments, investors get their initial investment and also get a set percentage return on their investment before the subordinate equity investor (i.e. the sponsor) gets even $1 dollar of cash flow.  If the investor does not receive a return of capital before the sponsor, or some other equity provider, then the investor is in a “common” or “JV equity” position and not a preferred equity position.

To help clarify these concepts, consider the following:

Preferred Equity (Investor receives return of capital AND preferred return before sponsor sees their first $1 of cash flow)

Capital Contribution:

Sponsor

10%

Investors

90%

Distribution Priority:

First Annualized Return

To investors until they reach a 10% annualized return

Second

Return of sponsor capital

Third

20% to investors and 80% to sponsor

In this example of preferred equity, the investors first receive their capital contributions plus a 10% annualized return before the sponsor receives any money. Second, the sponsor receives its capital contribution. Finally, investors receive 20% of all excess profits with the sponsor receiving 80% of all excess profits. The investors receive a true preferred return rate and, in exchange, they receive only 20% of profits over their 10% true preferred return.  Overall, the return is likely to be lower than if they participated in the upside in a JV equity position (as you’ll see in the examples below); however, their overall investment risk is lower.

The True v. Pari Passu Preferred Return

An investor in a common equity position can still receive a pref, and the type of pref can be further distinguished based on the treatment of sponsor capital, called the co-investment.  If the investor receives a preferred return (i.e. profits) before a sponsor does, then the pref is a “true” preferred return. However, if the investor and the sponsor receive the same preferred return, paid at the same time, then pref is a “pari passu preferred return.” With a true pref, the investor receives preferential treatment on their capital contribution; with a pari-passu pref, the investor does not.  Instead, the pari-passu pref acts as a threshold up to which investor and sponsor capital are treated equally and over which the sponsor capital receives a promote.

Common Equity with a True Pref (Investor receives preferred return before sponsor sees their first $1 of cash flow)

Capital Contribution:

Sponsor

10%

Investors

90%

Distribution Priority:

First

To investors until they reach an 6% annualized return on their initial investment

Second

Investor and sponsor return of capital pro rata

Third

60% to investors, 40% to sponsor

In this example of a common equity investment with a true pref, the investors receive a 6% annualized return before the sponsor receives any money.  In contrast to the preferred equity position described in the first example, here, the sponsor receives a return of capital pro rata with the investors.  And, anything above the 6% investor pref, investors and the sponsor divide excess profits 60% / 40% respectively.  The investors likely receive a lower pref, in comparison to a pari-passu pref (see below), because they get the benefit of receiving their preferred return before the sponsor sees any money. That’s why it’s called a true pref.

Common Equity with a Pari-Passu Pref (Investors and sponsor receive pref and return of capital side-by-side)

Contribution:

Sponsor Capital

10%

Investor Capital

90%

Distribution Priority:

First

To investors and sponsor until they reach an 8% annualized return

Second

Return of capital pro rata

Third

75% to investors, 25% to sponsor

In this example of a common equity investment with a pari-passu pref, the investors and sponsor each receive an 8% annualized return on their investments and return of capital, pro rata.  Above the 8% pari-passu pref, investors and the sponsor divide excess profits 75% / 25% respectively.  In this case, investors do not receive any profits before the sponsor does.  The pari-passu pref allows the sponsor to receive cash flow alongside the investors during the investment period.  The investors’ repayment risk is higher, but they also share in more of the profits.  In this scenario, the investors are treated as equal to the sponsor until the pref is paid and capital is returned. Beyond that point, the sponsor earns a disproportionate share of additional profits via its promote.

Simple v. Compounding Pref

The final item of note is that the pref is not always calculated in the same way.  Sometimes, the sponsor calculates the pref on a simple interest basis.  The alternative is a compounding basis.  Suppose that an investor is entitled to a 10% annual pref, but that in the first year, there is only enough profit to pay a 5% return.  In the second year, cash flow ramps substantially and pays a 15% return. In the simple interest basis, the additional 5% would still be owed next year but not added to the initial balance. In the compounding basis, the outstanding 5% would be added to the investor’s capital account for purposes of calculating the next year’s preferred return.  This example is shown below.

Non-compounding

Year 1

Year 2

Initial Balance

$100,000

$105,000

Amount owed

$10,000

$10,000

Amount paid

($5,000)

($15,000)

Ending Balance

$105,000

$100,000

Compounding

Year 1

Year 2

Initial Balance

$100,000

$105,000

Amount owed

$10,000

$10,500

Amount paid

($5,000)

($15,000)

Ending Balance

$105,000

$100,500

Notice in the compounding example, even the ramped-up 15% return did not satisfy the accumulated return owed.  It fell short by $500, which would then be compounded into the pref accrued for Year 3.  Over time, the compounded pref can generate substantially greater returns in the case of operating shortfalls in earlier years.

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