Will Preferred Returns Compress with Yields?

[Spencer Gray]

Hello BP community of multifamily investors, owners, operators, syndicators and managers. 

I'm curious to see what everyone is seeing and your thoughts on where preferred returns offered to limited partners are headed into the future.

Yields across almost every income producing asset class from bonds to stocks have been declining for years, and 2020 has only accelerated this trend with real yields (risk free rate or 10YR TBILL minus inflation) currently being negative. While low interest rates in 2020 have helped real estate deals with yield/cash-on-cash, the reality is that as the spread between interest rates and cap rates will normalize and many real estate deals may struggle to deliver a preferred return of 8% in the first few years of operations.

From my experience 8% has been the most common preferred return with 7% being the next most common. The lowest I have seen is 5% and the highest is 10%.

However investors return exceptions do not always align with market forces and sponsors are often hesitant to change the structure of their deals if their investors have come to expect a certain structure. 

For LP investors - how important is the preferred return rate to you vs the pro-forma returns or other terms of a deal?

For Sponsors - what are your thoughts on what you're currently offering and have you considered offering a lower preferred return if we see thinner cash on cash going into the future?  

For those unfamiliar with the concept of a preferred return - 

A preferred return, while not present in every deal structure, is a common return hurdle and deal element that provides investors of a certain class with a preferred position in the order of cash flow that is described in the operating agreement for a project. With a preferred return structure, after all expenses and debt service are paid, the next hurdle in the order is cash flow is to pay an annualized return to investors based upon their current capital account, or a preferred return. Only after that return threshold has been exceeded does cash start to be distributed on the next hurdle, often a split between the LP/GP. If there is not enough cash flow from a project to deliver the preferred return for a given period that amount accrues and must be paid before paying the current preferred return or next hurdle in the waterfall. This is a generic description and each deal structure can be a little different with some deals having no preferred return. For example: If a deal has an 8% preferred return then an investment of $100,000 should receive a pref return of $8k/yr in addition to any other available cash-flow that can be distributed. If the deal cannot pay the 8%, that $8k will accrue to future periods until it is paid.