What is a Preferred Return?
A preferred return is part of the real estate equity waterfall and is often referred to as a “pref”. A preferred return is often associated with limited partners in a commercial real estate project. Limited partners will usually receive a “pref” and will be the first to receive returns up to a certain percentage, generally between 6 and 10 percent. After this profit percentage is attained, the excess profits are then split among the rest of the investors (limited partners or LPs and general partners or GPs). The split is usually based on ownership percentages or an amount stated in the legal documents. Preferred returns are commonly used in commercial real estate investments.
Calculating the Preferred Return
The three main components that direct how the preferred return is calculated include:
1. Compounded or non-compounded?
When a preferred return is compounded, it means that its calculation comes from the amount of invested capital plus all the previously earned but unpaid amounts. Non-compounded simply means that the preferred return is only paid on the invested capital. In commercial real estate you will see both types, but non-compounded is much more common that compounded.
2. Cumulative or non-cumulative?
Cumulative means that the preferred return accumulated in one period that have not been paid by the end of the period are carried forward to the next period. Non-cumulative simply means that the preferred return resets every period and nothing is carried forward. Both types are common in commercial real estate investing.
3. How is the preferred return measured?
There is no single pre-determined preferred return structure that is used by all commercial real estate sponsors, but it is important for the sponsor to make clear exactly how preferred returns will be calculated in the investment.
True Preferred Return vs. Pari Passu Preferred Return
True Pref: With a true pref, investors or LPs will receive a preferred return before any money goes to the sponsor. As mentioned before, the preferred return goes to investors or LPs up to a predefined percentage return (usually between 6% and 10%).
Pari Passu Pref: With a pari passu pref, investors and the sponsor are treated equally up until the preferred return threshold is met for each party. Depending on the structure of the deal, the sponsor’s promote may kick in for remaining profit distribution above and beyond the preferred return threshold.
The Importance of the Preferred Return
You might be wondering how the preferred return is important since it appears to favor one class of investors. Ideally, the preferred return is a way to reward investors who are first to the table and who are also willing to give a large amount of cash to the investment.
In addition, a preferred return aligns the interests of the sponsor with the investors by forcing the sponsor to believe in an investment’s ability to reach beyond the preferred return. Otherwise, the sponsor will make little to no money on the deal.