What is a Preferred Return?

In this article, the expert team at CrowdStreet explains the different types of preferred returns.

A common feature of a real estate equity waterfall, the “preferred return” or “pref” can be particularly tricky for investors who are not familiar with its permutations.  Not all prefs are calculated in the same way.  In this article, we explain discuss the different types of prefs and distinguish these prefs from the “preferred equity” or “pref equity” position in the capital stack.

What is a preferred return?

A preferred return is a profit distribution preference whereby profits, either from operations, sale, or refinance, are distributed to one class of equity before another until a certain rate of return on the initial investment is reached.  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 subordinates the sponsor’s profits participation or “promote” (see our recent article: What is a Real Estate Sponsor Promote?) up to a certain return threshold.

 

Preferred Return v. Preferred Equity

The preferred return is distinct from the idea of “preferred equity,” which is a position in the capital stack that has a repayment priority.  The difference lies in the return on and return of capital.  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 gets even $1 dollar of cash flow.  If the investor does not receive a return of capital before the sponsor or some other equity tranche, then the investor is in a “common” or “JV equity” position and not a preferred equity position.

For further discussion of priorities in return of capital, please check out our capital stack article.

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 its 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.

To help clarify these concepts, consider the following examples.  The returns in these examples are not necessarily indicative of prevailing market rates.

Preferred Equity

Capital Contribution:

 

Sponsor

10%

Investors

90%

Distribution Priority:

 

First

To investors until they reach an 10% annualized return

Second

Return of investor 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 then 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; however, their overall investment risk is lower.

Common Equity with a True Pref

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 then sponsor receives any money.  The difference is that the sponsor receives a return of capital pro rata with the investors.  Above the 6% investor pref, investors and sponsor divide excess profits 60% / 40% respectively.  The investors likely receive a lower pref, in comparison to a pari-passu pref, because it is a true pref.

 

Common Equity with a Pari-Passu Pref

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

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 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. Cumulative 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.  Supposed 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 years 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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