Preferred Return Definition

What Is Preferred Return?

Preferred return refers to the minimum annual rate of return the limited partners (investors) can receive before the sponsor gets a share of the gains.

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How Does Preferred Return Work?

In real estate investments, the distribution waterfall—how gains are distributed to investors—is often complex. Preferred return is a feature of the distribution waterfall in which one class of equity partners gets distributions before other classes, until the preferred return on the initial investment is achieved. The preferred return, or pref, is usually expressed as a percentage, although it can also be expressed as an equity multiple.

preferred return

The preferred return applies to all profits, whether from operations, sale of assets, or refinancing.

True vs. Pari Passu Preferred Return

There are two ways to treat preferred returns[1]. In real estate, when the sponsor (also known as the general partner or GP) is not paid until the investors are paid the pref, it is called a true preferred return.

The other is pari passu, which means “on equal footing” in Latin. It means that both the sponsor and the investors are treated equally until the pref is met. The sponsor receives the “sponsor promote,” or all excess earnings beyond the pref.

Preferred Equity vs. Preferred Return

The main difference is that referred return applies to the return on equity, while preferred equity applies to the return of equity.

Preferred equity is a senior position in the capital stack. Preferred equity investors get their initial investment plus a contractual rate of return before subordinate investors are entitled to any cash flow. If an investor does not get return of equity before the sponsor, then they are in a common or joint venture equity position[2].

How Is Preferred Return Calculated?

The preferred return can be calculated in one of two ways: simple or cumulative. With cumulative pref, the investor gets the benefit of compounding.

Suppose investors are entitled to an 8% preferred return, but in the first year, there is only enough cash flow to pay 5%, leaving a 3% deficit. The following year, the asset earned 11%, just enough to cover the year-one deficit.

With a simple preferred return, the investor would get the full 8% in year two, plus the 3% owed from year one.

With a cumulative pref, the missing 3% in year one is added to the investor’s capital account, increasing the basis for calculating returns in year two. It sounds like a minor difference, but it can mean a substantial difference in overall returns when there are shortfalls in prior years.

Simple Simple Cumulative Cumulative
Year 1 Year 2 Year 1 Year 2
Initial Balance $100,000 $103,000 $100,000 $103,000
Amount Owed $8,000 $8,000 $8,000 $8,240
Amount Paid $5,000 $11,000 $5,000 $11,000
Ending Balance $103,000 $100,000 $103,000 $100,240

In the example above, the amount owed in year three with the simple pref would be calculated based on the $100,000 ending balance. With the cumulative pref, the amount owed in year three would be based on $100,240.

Two Common Preferred Return Provisions

There are a few other provisions that may be included in a preferred return distribution structure. 

  • A look-back provision means that at the end of the established return period, the GP and investors will “look back” to see if a predetermined rate of return has been achieved. Otherwise, the GP gives up a portion of their distributions until the investors receive the predetermined rate.
  • A catch-up provision means that the investors get all the returns until a certain rate of return is met, and then the GP gets all the returns until a certain threshold is reached[3].

Examples of Preferred Return

The following examples illustrate the above concepts and are not necessarily representative of current market rates.

True Preferred Return (6%), Common Equity

Investors Sponsor
Capital contribution 90% 10%
First distribution priority 6% 0%
Second distribution priority Pro rata return of capital Pro rata return of capital
Third distribution priority 70% 30%

In this example, investors get their 6% before the sponsor gets anything. However, the second distribution priority, pro rata return of capital, is the same for both the investors and the sponsor. Excess returns are split 70/30. The rate in a true pref is generally lower than the return in a pari passu pref.

Pari Passu Pref (8%), Common Equity

Investors Sponsor
Capital contribution 90% 10%
First distribution priority 8% 8%
Second distribution priority Pro rata return of capital Pro rata return of capital
Third distribution priority 80% 20%

In this example, both the sponsor and investors are treated equally until each receives the 8% pref and return of capital. Excess profits are split 80/20. The repayment risk for investors is higher with a pari passu, which is offset with a higher interest rate.

Preferred Equity, 10% True Preferred Return

Investors Sponsor
Capital contribution 90% 10%
First distribution priority 10% 0%
Second distribution priority Return of capital 0%
Third distribution priority 20% 80%

In this example, the investors get a return of capital and 8% returns before the sponsor gets a single dollar. However, the excess distribution split heavily favors the sponsor once the investor is paid. The investor would probably have higher overall returns with a JV equity position, but the risk with preferred equity is much lower.

Takeaways

Preferred return, or pref, is a profit distribution class by which the distribution waterfall—the order by which income is distributed to investors—prefers one class of partners before others. This prioritization is maintained until reaching a predetermined rate of return, upon which the income is distributed to other partners, such as the sponsor.

There are two common ways of treating a preferred return, depending on the partnership. Most prefs use the true preferred return method, as explained above. Others meanwhile use a pari passu approach, where both the sponsor and the investors get an equal share of the profits until a predetermined threshold. The sponsor receives any excess income beyond this, called the “sponsor promote.”

Sources

  1. Commercial Real Estate Loans. (2019.) Pari Passu in Commercial Real Estate. Retrieved from https://www.commercialrealestate.loans/commercial-real-estate-glossary/pari-passu
  2. Bloomfield Capital. (n.d.) Understanding the Differences Between Preferred and Joint Venture Equity. Retrieved from https://bloomfieldcapital.com/news/blog/understanding-differences-preferred-joint-venture-equity/
  3. UpCounsel. (2020.) Preferred Return: Everything You Need to Know. Retrieved from https://www.upcounsel.com/preferred-return

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