Lowest acceptable preferred return?

Question

This is an open-ended question given the differing types of markets and diversity of assets.

If you’re raising money from a pool of investors, what is the lowest cash-on-cash acceptable preferred of return that would be acceptable. Let’s say investors are contributing 25k - 250k for deals that are raising anywhere between 300k - 1.75m.

Example: if you put a deal together where the short term cash-on-cash return is 3%, would most investors balk or be satisfied? What do you think the lowest acceptable cash-on-cash return is for investors to be willing to assume the risk to invest?

Brian Burke · Answer

Welcome to BP, @Adam Silverman! (Just noticing this is your first post).I'm going to answer your question in two parts because there is no such thing as cash-on-cash preferred return. Cash-on-cash return and preferred return are two completely different things.A preferred return is a hurdle rate that is defined in the company's operating agreement, where until such time as an investor has received distributions achieving that rate of return they are entitled to 100% of all distributed cash flow, with no cash flow going to the general partner or managing member (sponsor) of the partnership. By way of example, let's say the preferred return is 8%. In the first year, distributions total 4% on the investor's money. The investor gets all of the distributions. In the second year, the distributions total 8% on the investors money. The investor gets all of the distributions. In the third year, the distributions total 12% on the investor's money. The investor gets all of the distributions, because in the first year they only got 4% and the remaining 4% of the 8% preferred return is still outstanding. In the fourth year, the distributions total 12% again. The investor gets all of it to the point that it equals 8% on any unreturned capital and the rest drops to the next tier of the waterfall, which usually means that that surplus portion gets split with the managing partner in some way.To answer your question, preferred returns can be whatever number the investors and manager agree to, but the most common range is 8% to 10%, with 8% being most common in my experience.It is possible (and common) to have a 10% preferred return on a three year investment and a 0% cash-on-cash return for the entire hold period. Think of a development deal, for example. There is no cash flow, but when the property sells at year 3 the investor has the preferred claim on the amount of cash that would give them a 10% return on their money and the rest is split however the remaining tiers of the waterfall are set up.Cash-on-cash return is not defined in the operating agreement, this is a performance metric calculated on actual performance. In the example above, the cash-on-cash return was 4% in year 1, 8% in year 2, 12% in year 3 and 8% in year 4 (plus whatever was distributed to the investor in the next waterfall tier so the final percentage would be higher than 8% in most cases, but not all).So what is the minimum that an investor will accept? Unfortunately there is no single answer here. Investors make individual decisions based on risk-adjusted return, their goals and objectives (cash flow versus capital growth), the business plan of the investment, and many other individual factors.I've done many deals with no preferred return and no cash flow and fully subscribed them. And I've done many with 8% preferred returns and average cash-on-cash returns in the high single digits and low double-digits. And deals where there has been small cash flow in the first year or two and growing steadily during the hold period. All have been fully subscribed. It just all depends on the investor and the deal.

Jack Martin · Answer

First of all, great advice from all those above! @Adam Silverman the answer to your question depends on three things: The sophistication of the individual investor and their investment goals - @Josh J. covered the sophistication quite well, but it has to do with their goals as well. Consider two investors with the same level of sophistication could have vastly different goals due to their age, the source of their investment capital, the length of time they would like to invest, etc. When you are talking to prospective investors it will be important for you to ask them what their goals are, as that will help you both better understand if your investment is a good fit for them or not. The fees you charge - Syndications commonly come along with a host of ongoing fees to the syndicator. The more fees you charge, the more investors will expect a higher preferred return and/or equity splits that favor the investor. The risk associated with the investment - As it is with any investment, the risk associated with the investment will influence the yield expectation, and the risk goes beyond how good of a deal you believe you have found. Here are a few risk associated factors for you to consider: Market Cycle - consider where we are in the market cycle and how the property you are syndicating will perform, should the market correct Type of Deal - investors will be exposed to varying degrees of risk related to the asset class and the strategy proposedInterest Rates - depending on your exit strategy, there may be risk associated with rising interest ratesOperator - investors will assume some level of risk depending on the amount of experience you have, so if you are just getting started you may have to offer more of the pie to your investors than you will in the futurePeace of Mind - this is an often overlooked risk that will have WAY more impact than you might expect. How you communicate, how you report, whether or not you are on time, the degree of transparency you offer, and everything related to making the experience for your investors the best one they have ever had. All those items done poorly will expose your investors to a high degree of risk with their peace of mind. I will tell you that most investors would rather sleep good at night knowing their investment is in good hands and get a lessor return, than they would want to experience the opposite for a higher yield. Your ability to understand and articulate the risk associated with your offering will go a long way toward you attracting the right investors, as well as getting clear on the answer to your question. All the best!Jack

Alina Trigub · Answer

@Adam Silverman Welcome to BP community! It's a great place to learn. While you already received a well-defined answer from a BP-pedia guy (aka @Brian Burke), prior to raising funds and/or syndicating, spend some time to learn how syndications work and consider partnering up with someone experienced in syndications. You may be well-versed in your niche, but syndications are a different world all together. So when dealing with OPM, one has to be extremely cautious, know the business really well and be able to calculate the investors returns and do full underwriting property. This doesn't prevent you from talking to investors. In fact, I'd encourage you to start reaching out to investors and learning the business simultaneously. Best of luck!

Josh J. · Answer

Adam, Brian explained it extremely well but I can add a couple of additional considerations.1. Minimum preferred return is going to be very dependent on the LPs sophistication and net worth.My fiance is a physician and I've met some really prominent orthopedic surgeons in her medical group at various functions. These are really high net worth guys who are sitting on a ton of cash making 50 bps in the bank. They're also unsophisticated when it comes to finance and they want to own multifamily deals in the NY Metro area forever. I'm doing a small deal personally (sub $3mm) with three of them and they're happy with a 5% preferred return and a 50/50 split above that. In addition, this is a "country club deal" where the preferred return is calculated based on the initial equity investment and it accrues but does not compound if there's a shortfall. Unsophisticated + high net worth often equals low preferred return requirements.2. Where are you investing?Investors in Manhattan multifamily properties are ecstatic with a 6% preferred return (not talking about ground up development, but a value-add acquisition). We're doing a value-add deal in Manhattan as we speak with a 6% pref and 70/30 split above that. But I spoke with these LPs about another deal we're looking at in Oklahoma City recently and they want a 9 pref, 80/20 to a 12, 70/30 to a 15 and 60/40 thereafter. The perceived safety of an investment is going to have a strong impact on the required hurdle rates for a preferred return.

Sherwin Gonzales · Answer

@Adam Silverman great question and I see that many people have already answered you in such detail. Here's a thought tho...Why don't you just ask your investors what kind of returns they are looking for? What are their goals? What are their interests? Why do they want to get into real estate investing? I think often times people are quick to jump the gun and market their preferred rate or cash on cash return without even getting to know the investors' needs first. Once you learn more about them, the better you can fit them with the proper deal when it comes along.Make money the way you make friends.Good luck to you!

Spencer Hogan · Answer

@Adam SilvermanIt really depends on the investor and the risk-adjusted returns. Some investors are more focused on appreciation / IRR and don't care so much about cash-on-cash. An extreme example would be a development project where most equity investors do not anticipate any cash flow until stabilization. Cash flow distributions should be at the discretion of the sponsor. It is somewhat common for sponsors to not distribute any cash flow to investors while capital improvements / renovations are underway until the project is stabilized. The reason is that sponsors like to build up cash flow reserves out of the gate to mitigate the risk of a capital call in case costs exceed the CapEx budget. A strategy that I have seen to improve cash-on-cash returns is to overcapitalize the deal upfront and distribute the excess working capital to investors while the project is being renovated. This strategy will hurt the IRR though. I highly advise being very transparent with your investors to manage expectations.

Sam Shueh · Answer

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Luke Miller · Answer

@Adam Silverman i'll just add one short item as well. This 8% to 10% pref range is as it exists today. The market fluctuates and as deals become more plentiful, the terms for investors will become sweeter. If there are no deals available, you'll see that pref go down and the sponsor will keep more of the deal. It wasn't too long ago what some "gurus" in the syndication world were teaching that if you have to give up a pref, you need to take a large chunk of equity. This is something most experienced investors would laugh at right now. Good luck!

Brian Burke · Answer

Yes, new construction and deep value-add with sale upon stabilization are two examples of deals with no cash flow. That doesn't mean they don't have a preferred return, however. It's just likely that no distribution will be made to satisfy that preferred return until the proceeds from the sale are distributed.There are examples of no pref and no cash flow. I did a deal like that a couple of decades ago when I set up my first fund to invest in single family flips. There was a 50/50 split and no preferred return. And no cash flow, the investor's share of the profit remained in the fund to be used to fund additional purchases rather than being distributed, until the fund wrapped up after 5 years.

Adam Silverman · Answer

@Brian Burke. Thank you for the thoughtful response!I have one follow up question if you don’t mind.A deal with no cash flow and no preferred return, what would that situation look like?The only things I could think would be new construction or buying underperforming assets that need some sort of significant turnaround. Essentially deals where the existing cash flow of the property would not be able to support immediate distributable cash flow. Are there other scenarios, am I getting something wrong?I’m trying to better understand general investor mindset (I realize all investors are different with their goals).