Preferred Return – Definition
A preferred return means that the party that has the preferred return, the investor, will be paid first before any promote (sponsor premium) 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 to the investor, simply that the Sponsor will not receive their promote until the preferred is satisfied.
First Things First
Why do Deal Sponsors do Syndications?
The obvious answer to this question is to make money. Most syndicators or deal sponsors do this as their “job” and to make a living. In order for the syndication to be worth the hassle, stress and risk they must be compensated or there is no reason to do it, they may as well just invest their money with someone else.
A common deal structure is to have an acquisition fee, refinance fee and disposition (sale) fee as well as the preferred return.
When the Sponsor offers a preferred return they will usually not receive any compensation until that preferred return hurdle is met (the exception is if they invest their own dollars as well, then they would actually receive the preferred return themselves on their investment)
As an example, if the deal has a 6% preferred return and the first year has 6% in cash flow distributions then the sponsor will receive no premium compensation for running the deal. If there were to be 8% in cash flow distributions then the sponsor would receive their promote (80/20 or 70/30 split, etc…) on the 2% excess. Most people in the world pay their bills from monthly earnings or cash flow (think about your paycheck if you work for someone) and if most if not all of that cashflow isn’t there then they have to do something to make up for that lack of cash flow. This is where the various fees come in, remember, if they aren’t compensated in some way for running the deal they wouldn’t take it on.
A closer look at an acquisition fee
An acquisition fee is a legitimate thing and is there to provide the sponsor with a source of income for managing the deal.
In my case, many of the deals that I do are in the $20,000,000 range and if I charge a common fee of 2% that would pay me $400,000 for putting the deal together. The issue here, at least for me, is that this is a sunk cost to the LLC and is paid to me before I perform at all. If I try my best but the deal goes south and we don’t make any money (yes, that can happen 😉 ) well, I still got “mine” in the form of that $400,000 acquisition fee. I don’t like this approach and feel a bit uncomfortable with the fact that regardless of the investment outcome I still got paid.
What some sponsors will choose to do is align their compensation better with the investors by not charging these fees. As mentioned above, to do this deal the sponsor has to be paid in some way so in this case there would likely be no preferred return. I personally live on cash flow and not on receiving huge chunks of money periodically.
You can look at this as a compromise, for me as the sponsor to not offer a preferred return I am willing to give up the fees. I would prefer the more consistent and regular cash flow to the sporadic fees.
Some might argue that the preferred gives them a guaranteed return but that is in no way accurate. If the deal doesn’t provide enough profitability to pay that preferred return then the investor will not receive it.
One other key thing to understand as the deal sponsor, by charging that one time $400,000 fee in the above example, the sponsor is going to have a hell of a tax bill for that income. If your effective tax rate is 25% that’s 100k, ouch!!
Recap and Final Thoughts
- By charging these fees the interests of the sponsor and the investors might not always be in complete alignment.
- By forgoing this large income piece it helps the sponsor better manage their personal budget since the cash flow is more regular and consistent than a one time fee.
- When a sponsor charges these fees it could incentivize them to do more and more deals as that’s when they make the bulk of their income. It may not always be wise to do that next deal but to continue making money they feel compelled to do it. This thought is similar to the flipping dynamic; you have to always do the next deal to keep your earnings flowing.
These are just my thoughts on why you might not be offered a preferred return when investing in a syndication. It is up to you as the investor to understand how the deal is being structured and to decide if it’s a fit for you and your investing objectives.
Like most things, there is no “right” or “wrong” way to do this, simply different approaches. Part of being a sophisticated investor means you should understand what they’re doing.
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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.