What is a Preferred Return? How Do They Work in Real Estate?

In this article, we’ll explain the preferred equity in private real estate, including why it aligns with the interests of multifamily investors. We’ll explain the different types of preferred returns so you can invest with confidence. Any financial targets or returns shown on the website are estimated predictions of performance only, are hypothetical, are not based on actual investment results and are not guarantees of future results. Estimated targets do not represent or guarantee the actual results of any transaction, and no representation is made that any transaction will, or is likely to, achieve results or profits similar to those shown. Preferred stock issuers tend to group near the upper and lower limits of the credit-worthiness spectrum.

The inherent value of preferred stock is the ongoing cash proceeds investors received. However, because it is not tied to semi-fixed payments, investors hold common stock for the potential capital appreciation. If you’re reading this article, you’re probably currently investing in real estate or you are looking to learn more about real estate investing. Understanding preferred returns in private real estate investment offerings is key to putting yourself in the best position to achieve the highest returns from your real estate investments possible. A common aspect of the waterfall structure in a  real estate investment offering will include a preferred return, also referred to as a “pref.” So what does a preferred return mean in real estate, and how do they work?

After that, the manager will share disproportionately in the profits because they have generated a return more than the preferred return. If John had invested $150,000, he would have received $9,000 in annual distributions, or 6%, before the real estate sponsor/syndicator took any distributions. The remainder of net cash flow from the property will be divided with the sponsor, with the passive investors receiving 60% and the sponsor receiving 40%, following John’s payment of the 6% preferred return. It is a straightforward illustration of a preferred return in multifamily real estate.

Noncumulative Preferred Stock

This shows how important it is to the sponsor that the preferred return is a feasible number to achieve, otherwise it’s disadvantageous for the sponsor to promise that percentage. As one can see from how a preferred return is structured, this favors the investor in times when the economy may take a downturn. When the economy hits a recession, or if the property is going through a period with unusually high expenses and does not have the ability to pay the full preferred return, the investor has a bit of a safety net. We have covered all bases regarding preferred return real estate investing.

• To determine the capital account balance, the capital balance not returned is multiplied by the preferred return amortized for a particular period.
• The last point to mention, which again benefits investors, is the fact that preferred return interest is typically accrued.
• In this article, we discuss the different types of prefs and distinguish these prefs from the “preferred equity” or “pref equity” position in the capital stack.
• First, preferred stock receive a fixed dividend as dividend obligations to preferred shareholders must be satisfied first.

If a company is struggling and has to suspend its dividend, preferred shareholders may have the right to receive payment in arrears before the dividend can be resumed for common shareholders. If a company has multiple simultaneous issues of preferred stock, these may in turn be ranked in terms of priority. The highest ranking is called prior, followed by first preference, second preference, etc. Secondly, preferred stock typically do not share in the price appreciation (or depreciation) to the same degree as common stock.

A company can issue preferred shares under almost any set of terms, assuming they don’t fall foul of laws or regulations. Preferred shareholders have a prior claim on a company’s assets if it is liquidated, though they remain subordinate to bondholders. Preferred shares are equity, but in many ways, they are hybrid assets that lie between stock and bonds. They offer more predictable income than common stock and are rated by the major credit rating agencies. In terms of similarities, both securities are often issued at face value or par value. This value is used to calculate future dividend payments and is unrelated to the market price of the security.

Voting Rights, Calling, and Convertibility

Additional information is available in CrowdStreet Advisors’ Client Relationship Summary (Form CRS) and Form ADV. Notice in the compounding example, even the ramped-up 15% return did not satisfy the accumulated return owed. It fell short by $500, which would then be compounded into the pref accrued for Year 3. Over time, the compounded pref can generate substantially greater returns in the case of operating shortfalls in earlier years. For further discussion of priorities in return of capital, please check out our capital stack article.

In this example of a common equity investment with a true pref, the investors receive a 6% annualized return before then sponsor receives any money. The difference is that the sponsor receives a return of capital pro rata with the investors. Above the 6% investor pref, investors and sponsor divide excess profits 60% / 40% respectively. The investors likely receive a lower pref, in comparison to a pari-passu pref, because it is a true pref. To summarize, the preferred return is simply a rate of return tier that defines various profit splits. Once a capital account balance reaches $0, a fund manager typically starts participating in profits.

Simple v. Cumulative Pref

However, a few frequently asked questions (FAQs) regarding the preferred return in real estate are to be answered. In addition to being cumulative, the preferred return can accrue if that’s a provision specified for the deal. Target average cash yield is calculated by taking the average of a property’s projected annual net cash flows, and dividing by the initial equity investment amount. Investments in private placements are speculative and involve a high degree of risk and those investors who cannot afford to lose their entire investment should not invest. Additionally, investors may receive illiquid and/or restricted securities that may be subject to holding period requirements and/or liquidity concerns.

• If shares are callable, the issuer can purchase them back at par value after a set date.
• It’s also a way to show to your investors that you believe you will not only reach the percentage return that you have promised them but exceed it to pay other investors.
• The information provided does not take into account the specific objectives or circumstances of any particular investor or suggest any specific course of action.
• How valuable convertible common stocks are is based, ultimately, on how well the common stock performs.

Some issue preferred shares because regulations prohibit them from taking on any more debt, or because they risk being downgraded. On the other hand, several established names like General Electric, Bank of America, and Georgia Power issue preferred stock to finance projects. Out of both examples given, the only scenario in which a deal sponsor gets paid is if they keep the asset performing at an optimal level.

Interested In Learning More About PASSIVE Real Estate Investing In Multifamily Properties?

If the investor does not receive a return of capital before the sponsor or some other equity tranche, then the investor is in a “common” or “JV equity” position and not a preferred equity position. In this example of a common equity investment with a pari-passu pref, the investors and sponsor each receive an 8% annualized return on their investments and return of capital, pro-rata. Above the 8% pari-passu pref, investors and sponsor divide excess profits 75% / 25% respectively.

With preferred returns and terms such as private equity fund and preferred equity understood, it’s time to discuss what preferred return implies for multifamily investors. Preferred return, in its simplest form, relates to how earnings from a real estate investment are dispersed among investors. This distribution retains its top priority until a specific threshold rate of return is reached. Any other inferior investors are given their profit allocation once the goal has been reached. A capital account in a real estate investment is essential to understanding the preferred return. A capital account is an individual account of each person’s money as it rolls up to the overall investment.

What Is Preferred Return?

Once you reach this profit percentage, the excess profits are split among the rest of the investors as agreed upon in negotiations. It is possible that an investment is being wound down and, consequently, the capital account balance is positive. Continuing the example above, let’s assume that the $500,000 investment is liquidated on June 30 for $400,000.

In this case, investors do not receive any profits before the sponsor does. The pari-passu pref allows the sponsor to receive cash flow alongside the investors during the investment period. The investors’ repayment risk is higher, but they also share in more of the profits.

With an 8% preferred return and distributions are paying out at 7%, the sponsor did not hit the 8% preferred return. There is a deficit of 1%, this percentage is accrued, and must be paid out to investors the following year. Meaning in year 2 of the investment project, the investor will receive the usual 8% preferred return along with the 1% from year one, totaling a 9% return, before the sponsor can receive any returns. From this example, we can see why a deal sponsor must be highly motivated to ensure the performance of the asset, above the investor’s preferred return. The preferred return in multifamily property investment alludes to the precedence of investors’ receiving a specified return hurdle before the deal sponsor in the distribution of profits to investors.