Why you should want preferred returns

Before you commit to an investment, you’ll want to know if the operator is offering a preferred return. A preferred return is an agreed-upon return rate to be paid back to the investor before the operator makes any profit. If an investor puts $200,000 capital into the project and the annual preferred return is 8%, then they would receive $16,000 in annual income before the operator receives a share of the annual profits.

Preferred returns indicate how returns are paid out to the investor before the operator receives any portion of the profits. It’s essential to understand the preferred return of any investment opportunity because it allows you to examine the profitability of the project and how it will benefit your financial situation. It also ensures that the investor and operator see eye-to-eye about how capital and profits will be distributed.

Cumulative vs. non-cumulative returns: which is better for the passive investor?

There are two types of preferred returns: cumulative and non-cumulative. A cumulative return allows for any extraneous return not paid back to the investor in one year to be added to the next year’s return. For example, if you as an investor only received 6% of your capital back instead of the agreed-upon rate of 8%, the 2% you didn’t get back would be rolled into your next return, increasing it to 10%.

A non-cumulative preferred return would work out perfectly fine if the investment could pay your 8% back to you every year. However, if it only paid you back 7%, you would be ineligible to reclaim that remaining 1% at a later date.

Cumulative returns protect you as an investor because they do not limit the overall returns on your initially invested capital. They are widely accepted and used, and it’s best practice to be wary of any investment proposal with non-cumulative returns.

What is operator catch-up?

A preferred return with operator catch-up allows the operator to receive most of the returns for a period of time after the investors have made their preferred return. Since the operator forgoes initial profit to make preferred returns to investors, this period allows the operator to catch up on their own returns to achieve the initial profit split, such as 80/20 or 70/30. Using our 8% preferred return example with operator catch-up and an 80/20 split, the operator would take the next 2% of profits after the investors get the first 8%. Any remaining profit would be split 80/20 between the investors and operator.

How the preferred return can go away

Preferred returns are calculated in one of two ways. They are either calculated as a return from your initial capital or a return on your initial capital. A preferred return from initial capital might look appealing because you won’t have to pay tax on that cash that you receive as a return. However, since your return is calculated as a percentage rate on your initial capital, each yearly return from initial capital will reduce the amount of capital you have in the investment, diminishing the return you receive each year.

Return on capital ensures that since your initial capital in the project remains the same, so will your preferred return rate. A return on capital is considered new income and therefore is taxable, but it also leaves your initial investment (and equity) in the company alone.

The benefit to refinancing

Capital events like a refinance allow investors to reduce their unreturned capital in an investment without reducing their equity. During a refinance, each investor receives back a portion of their unreturned capital. Any preferred returns after that point will be based on the remaining balance left in the project. This means that if you have $200,000 in the investment before a refinance and take out $60,000, the preferred returns you receive in the future will be based on the $140,000 of remaining capital.

Keep in mind that your equity in the project will remain the same, just as it does when you refinance a mortgage on personal property. A refinance allows you to maintain equity in the investment while freeing up your capital for your own use.

The importance of preferred returns

One of the most important aspects of any investment is understanding both how you will receive profits and how you will recoup your capital. It’s crucial that each investor feels confident in the preferred return rate and the terms that come with the project; that returns are cumulative and that equity in the investment will remain constant. Be vigilant when studying how the preferred returns of a potential investment will work and how they will benefit you. It allows you, the investor, to see eye-to-eye with the operator and gain trust in the potential of your investment.

Interested in investing?

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