Recently, a lot of the value-add deals we have been underwriting will produce less cash on cash returns during the beginning years of the project than the deal's preferred return. Whether talking to potential investors, or looking to do a passive investment yourself, I wanted to share an overview of how preferred returns impact your cash flow as an LP investor.

A common misconception is that preferred returns are a representation of how much of a cash on cash return an investor can expect to receive upon every distribution. While both important to investment metrics, preferred returns have separate implications for distributions than the projected cash on cash return to investors.

Preferred Returns

Preferred returns relate to the waterfall structure of how cash flows from the underlying asset are distributed between limited partners (LPs or investors) and the general partner (GP or the sponsor). A preferred return is a minimum return threshold provided to investors prior to the payment of any performance compensation or promote to the sponsor. For example, in a scenario with an 8% preferred return and a property that produces 10% in a year, investors are entitled to 8% as the tier one hurdle before the sponsor begins to participate in any split of the 2% excess free cash flow of the property. This is of course assuming that the property is producing returns above the 8% IRR threshold. But what if the property isn't?

Preferred returns not only have different rates, but also differ mechanically. Preferred returns can either be compounding or non-compounding. A compounding preferred return means that shortfalls are not simply accrued but are also compounded with interest at the preferred return rate. This protects investors from any losses on a time value of money basis, and protects investors in the event of cash flow distributions that are less than the preferred return. Non-compounding preferred returns, on the other hand, carry no penalty to sponsors in the event the property and sponsor do not meet the preferred return distributions.

Another mechanical difference in preferred returns structures is whether they incorporate a return of invested capital to LPs. Here, passive investors are entitled to their preferred return as well as 100% of their original investment prior to any profit sharing with the sponsor. This type of preferred return provides additional protection to investors since they would not pay any performance compensation to the sponsor until after they had received back their original investment, as well as whatever the preferred return rate is for the deal. Once a preferred return and any of its mechanics are satisfied, then the sponsor begins to receive performance compensation or the promote.

Cash on Cash Returns

Cash on cash, also called cash yield, relates only to the total return from forecasted cash flows from the property, as opposed to the order in which they are paid to LPs and GPs. A cash on cash calculation is a return metric that measures the return on the actual cash invested, excluding leverage. Annual cash on cash is measured year over year by dividing the annual free cash flow by the total capital invested overall. Investors should also consider the average of these values to get their total average cash on cash for the full cycle of the project.

Preferred Returns Implications on Cash Flows

Putting these mechanics together, let's say the average cash on cash for the hold period is 7%, while the preferred return is 8%. Especially in a low cash flow environment, having a lower cash on cash than the structured preferred return is not an immediate indicator that investors will not see considerable returns, especially if the preferred return is structured in an aligned manner. This is where the aforementioned compounding and return of capital mechanics of a preferred return comes into play.

The shortfalls between the average 7% cash on cash returns available for distribution and the 8% preferred return entitled to investors accrue and compound for the years the returns are short, yielding later returns for investors upon a capital event as payment for waiting for their returns. If also structured with a return of capital mechanic, the LPs investment and preferred return are largely protected if the proceeds from a capital event are high enough. The returns to investors upon a refinance or sale in a deal with this structure would include a 100% return of capital, the 8% preferred return, as well as any interest compounded from previously short distributions. So while a preferred return that is higher than the average cash on cash does not mean investors are guaranteed an 8% annual return, it also does not mean that investors will not be repaid for the preferred return if it is structured properly.

Overall, preferred returns do not directly equate to cash on cash returns for each distribution. Investors who are looking specifically for the cash flow of the asset should look at the average and annual cash on cash returns. Also note that for this example we have assumed that the preferred return tier one hurdle type is based on IRR, has a compounding preferred return, as well as a 100% return of investment, which is how Rulteus Capital Group structures its returns to investors. Investors should always clarify with sponsors how their waterfalls are structured to ensure how their expected distributions are being calculated. Furthermore, we would advise that investors are skeptical of investment opportunities that do not include preferred returns as this typically does not align incentives between investors and sponsors.

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