So, what is a preferred return? A preferred return means that the party that has the preferred return, the investor, will be paid first before any promote or “Carry” is paid to the deal Sponsor
Preferred returns are a way to subordinate the interest of the Sponsor to those of the investor. This does not give any guarantees or safeguards, simply that the Sponsor will not receive their promote until the preferred is satisfied.
Now that we understand the basic definition we need to look at a couple variations of the preferred return.
- First, is it a true pref or pari passu?
- Next, is the preferred return compounding or simple?
Simple or Compounding
The most common approach that I see is that of the Simple Preferred Return which means that if the preferred return is 6% then the first 6% distributed goes to the investors (the Sponsor will often have their own money invested so for this contribution they will normally receive preferred return benefits which is independent of their promote). Once the “hurdle” rate has been reached and satisfied the Sponsor will take their promote, also know as their Carry, on all distribution dollars above the preferred rate.
Example – Investors contribute $1,000,000 with the 6% preferred return and a promote structure of 80/20. Year one has 8% of distributable profit which is $80,000. The first 6% or $60,000 of the distribution goes to the investors and the remaining $20,000 is split 80/20 where 80% goes to the investors and 20% goes to the deal Sponsor.
In the “Simple Preferred” instance, if in the first year there is only 5% distributable profit then the 1% miss is not added to the year two hurdle. In some deals if this happens then any of the yearly misses are accrued and paid when the property is sold so as to make the investors whole with regard to their preferred earnings.
Another approach is to have the preferred return be compounding meaning every dollar of shortfall in year one gets added to the investors capital account and then years two’s pref is calculated on the larger capital account
Example – Same $1,000,000 invested but this time in year one the distributable profit is only 5% or $50,000. In this case the miss of $10,000 would get added to the capital account balance for year two so the investor capital account would now be $1,010,000 and with a 6% compounding preferred return the hurdle for year two is now $1,010,000 x 6% or $60,600 and not the $60,000 from year one.
True or Pari Passu
In a True Preferred Return the limited partner or passive investor gets all of the return until the hurdle rate is hit and then the overage is split between the Sponsor and the Investors based on the Sponsor’s promote (80/20 or 70/30 in this article).
Pari Passu on the other hand means that the sponsor shares in the return up to the stated hurdle rate and then everything over and above the hurdle rate is to be split according to the stated promote split. In this scenario the Sponsor doesn’t get their promote or premium unless and until the investor gets their preferred return satisfied
One very important thing to understand, if the project never generates the preferred hurdle rate, not even at the time of sale of the property, then the investor will never receive the full stated preferred return as the deal didn’t produce the profit needed to make the full preferred distribution.
As you can see, there are many ways to structure a preferred return so it’s important, if there is a preferred return being offered, that you understand exactly how it is structured. There is no right or wrong approach to how a Sponsor structures their Preferred Return or even if they offer one at all, you just need to understand what they are presenting to you as the investor.
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Known in the real estate world as the Apt-Guy℠, Bruce Petersen is a serial syndicator who started with a 48-unit building and has now syndicated over 1,100 units. As the founder and CEO of Bluebonnet Asset Manager LLC and Bluebonnet Commercial Management, Bruce is a #1 Best Selling Author and has received local and national recognition for his syndication efforts. He was the recipient of the Austin Apartment Association’s Independent Rental Owner of the Year for 2016 and the National Apartment Association’s Independent Rental Owner of the Year for 2017. In addition to being a TV personality and public speaker, Bruce also mentors people on how to invest in apartment complexes.