Preferred Returns – What’s The Point?

Often people that are new to investing think that real estate transactions have to necessarily be overly-complex and abstruse. After all, most private equity deals are laden with large operating agreements, private placements, subscription agreements and rather complicated legal documentation. There is certainly no denying that all of this documentation can be burdensome for a layman and thus the SEC and state securities commissions want to make sure that promoters must follow strict rules when soliciting investors for money. Investor protection is a paramount concern and the regulators despise the concept of guarantees or anything that smacks of an unrealistic amount of return a project can deliver.

Truth be told, no investor no matter their level of sophistication can guarantee anything. The world is simply too complicated and there are uncontrollable risks like the mortgage crisis, geo-political risks, currency risks, inflation risk, etc. that at times will drastically impact a given project in ways that the promoter could have never foreseen. If you examine a properly documented private placement it will specify tens or hundreds of things that can possibly go wrong. It is kind of like watching a pharmaceutical commercial where they spend 90% of the commercial telling you how perfect the drug is and the last 10% listing all of the side effects and what can go wrong.

So if a promoter can’t look into their crystal ball and tell what is going to happen in the future and they can’t guarantee anything what is the next best things they can do? Enter the concept of a preferred return. A preferred return is simply a benchmark threshold an investment must hit before the promoter is able to participate in any profits. So if the threshold is set at 8% this would mean that the investment has to return this amount before any participation would be realized by the promoter. It is then typical for the remaining profits to be split in some fashion among the investors and the promoter based on what was specified in the agreements.

One of the primary concerns you as the investor should have when investing in a syndicated real estate transaction is alignment. Heavy fees in projects can create misalignment between those supplying the capital and those utilizing the capital to invest in a given project. A certain grade school sense of fairness should be applied in all situations. A preferred return helps to create alignment along with fairness in a real estate profit sharing arrangement. The investor has preference to any pool of profits that comes from a project and the promoter is only allowed to participate if they deliver enough dollars on the money invested for there to be excess after the preferred minimum is paid. Thus promoters will only select projects with that will clearly clear the hurdle of the preferred return so they can maximize their chances of being able to participate in projects.

An investor that wishes to create additional alignment should carefully examine whether or not the fees to the promoter are paid before or after the preferred payments as well. Payment of fees prior to preferred payments could potentially incentivize the promoter to take projects that maximize their chances of making fees instead of the ones that will make the most money for the shareholders. This is a classical problem with real estate brokers who operate under straight commission. The true goal of those operating under this structure is to err on the side of making sure the transaction happens instead of making sure the project is the best one for those with the money at risk.

In summary, investors should seek maximal alignment between themselves and the promoter asking for them to invest their hard-earned money. There are many things that should be closely examined in complex real estate structures, but one of the primary things investors should scrutinize is alignment. Preferred returns help to create alignment as does making sure that the promoter largely gets paid at the same time as the investor instead of deriving much of their income from fees that are payable regardless of how successful the transaction turns out. Following these high-level guidelines when examining investors will serve to protect you when you choose among many investments available.