Lowest acceptable preferred return?

[Adam Silverman]

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]

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.