How does a preferred return work?

Question

Hi BP Community,

I am currently looking into a 19-unit apartment complex in Chicago and after speaking with other investors, the term "preferred return" kept popping up. Can someone provide a simple example as to how this works? How does it affect the cash flow per month and then when it comes time to sell the property?

Thanks!

Greg Scott · Answer

A preferred return is one of many different flavors of profits offered by syndicators.  Some also call this a waterfall return.

In a preferred return scenario the passive investor (aka limited partner) is told they get a certain % return before the syndicator gets any profits. This scheme appears to work well with investors that are primarily used to stock investing. A syndicator will typically offer a 8 or 9% preferred return. Uneducated investors will see this as a "sure thing", because they will make more than they did in the stock market, with some potential upside beyond their preferred return. These investors believe they are getting paid first.

In reality, most syndicators make a ton off of operational fees before any preferred returns are paid to the passive investors.  If the deal sucks, the syndicator is going to make money off of almost zero net investment in the deal and the passive investor won't make much on their investment, even though they had all the financial risk.  If the deal is a home run, the passive investor will do well, but the syndicator will make a killing. (It is critical to fully read the operating agreement and actually do the math on how returns are paid before investing)

As a syndicator and also a passive investor myself, I never invest as a limited partner in any deal that offers a preferred return. I only invest in deals with limited fees and a straight percentage share between the syndicator and the passive investors.

Some will hate me for posting this.  Bring it on!

John Warren · Answer

@Ryan DiCanio you only need to worry about a preferred return if you do a syndication structure pretty much. Are you planning to purchase this yourself? Will you use a JV partnership? when you make the jump to these mid-sized multifamily buildings there is a lot to learn. If you end up trying to put together a small syndication deal, just know that the costs eat up a lot of cash for a smaller deal. The attorney paperwork is around 9-12k for the initial setup, and then you still have all your other closing costs.

Paul Moore · Answer

HI @Ryan DiCanio! I recommend you buy the latest version of Gene Trowbridge's book It's a Whole New Business. This book explains syndication, and all kinds of terminology you will need to know. And it will help you understand the mechanics of investing in commercial real estate.

You may also want to join Jim Pfeifer's Left Field Investors group. This is a group of like-minded investors who can offer a lot of value.

Happy investing!

Paul Kingsley · Answer

Ryan - good feedback above.  A simple example of a "waterfall" (a fancy way of saying - the order you are returning available money to interested parties) is:

a) Investors (limited partners) receive an annual accruing 8% preferred return (the 8% is calculated based on an investor's capital contributed); then

b) Investors receive a return in full of their capital contributions; then

c) Investors get 50% of any additional profit and sponsor gets 50% of any additional profit (commonly referred to as the sponsor's "promote" or "carried interest")

During the operation of a property, often a sponsor will only be able to pay some of the accruing preferred return out of cash flows - after expenses, debt service and reserves are accounted for.  Any unpaid pref just accrues.  Then when a project is sold, all remaining funds available for distribution will "waterfall" through the a) through c) levels as they are distributed out to the interested parties.

As noted above, the distribution waterfall is only utilized for cash available for distribution - so that means after all fees, expenses, debt service and reserves are paid or accounted for.

And of course, none of the distributions in the waterfall (not even the preferred return) are "guaranteed" - as equity in a project typically sits in last place in order of distribution priority.  So if cash flows are too low to distribute pref, the pref just accrues.  And after the property is sold, debt is paid off, all expenses are paid, and reserves for contingent liabilities are accounted for, if there is only $500,000 left to distribute to investors who put in $1,000,000, then investors are only getting back 50 cents on their invested dollar (and obviously, the preferred return itself is basically meaningless).  If on the other hand, there is $2,000,000 left to distribute, then you'll likely distribute all the way down through the entire waterfall and everyone leaves happy.

That's just scratching the surface of syndication structure and contains lots of generalizations, so please get good legal counsel and don't forget to ask them about securities laws compliance if/when you are raising funds from investors.

Ronald Rohde · Answer

A pref is paid first (almost treated as an expense) at a financial return level. It should be distributed to catch up any unpaid pref returns upon a sale, but thereafter should not affect distributions. 8% pref was the old standard, so invest $100k, get 8% a year before another investor gets his cut (return of principal or gain). Upon sale, you'll be on even footing based on size of investment/class, etc. $100k =$100k

Ryan DiCanio · Answer

That helps explain it clearly to me! Thank you - so its safe to say you only like to invest in deals when all partners are invested financially in them?

Chris Seveney · Answer

@Ryan DiCanio

Lots of great comments below, one thing I recommend when reviewing a syndication is if it’s truly a preferred return. Meaning if the fund is collecting acquisition fees, disposition fees etc on top of management fees - are you truly getting a preferred return as those are typically major profit centers for the sponsor.

It’s good to make sure you understand the entire process. We wrote two blog posts on bp on this topic of questions to ask your sponsor

Jonathan Klemm · Answer

Hey @Ryan DiCanio - You were provided solid incites above, but it more or less just means you will pay your investors back first at a specific rate.  We are looking at doing syndications as well here in Chicago.  Let's connect!

Greg Scott · Answer

Yes, I only invest in deals where the syndicator has skin in the game.  BEWARE, many syndicators give themselves an "acquisition fee".  I've seen syndicators advertise that they are putting $1M of their own money in a deal but the fine details of the PPM show they are getting most, all, or more of it back at closing.  Many syndicators out there have already made their profit the day the property is bought. Anything they make after that is gravy.

I only invest with syndicators that do well when I do well as an investor.  As a result, for our syndications, we set it up so we only do well when our investors do well.

Ryan DiCanio · Answer

John I have been looking into a 19 unit commercial property and planning on getting investors to finance the deal. It is a 1.75MM deal so I would not be able to finance it myself.

How does a preferred return work?

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