Preferred Returns Explained
What Are Preferred Returns in Syndicated Real Estate Private Equity?
Every Real Estate Private Equity (REPE) deal is unique, both in terms of its investors and the debt levels inherent in the project. Naturally, this results in different priorities for investment returns. The pref, or preferred return, is the logical result.
Preferred returns should preserve the investment of the limited partners (LPs) who make the largest capital outlay in real estate syndications. The general partner (GP) indirectly benefits from preferred returns, because he can use his ability to offer this special treatment to ensure that the syndication’s interests and those of passive investors are aligned. Being first in line to receive cash flow proceeds can be a powerful incentive.
Preferred returns are crafted in many ways, and many terms exist for pref, including investment hurdle, first money out or waterfall arrangement. Regardless of the label, the idea is the same—a method by which payment is made first to select capital investors.
What Is a Hurdle in Preferred Returns?
The waterfall arrangement is used by many sponsors to craft their transactions. In such a transaction, a hurdle is established. For example, the initial hurdle might be an eight percent preferred return, meaning LPs offered this pref will receive one-hundred percent of profits until the investment reaches an eight percent return. Once that hurdle is reached, the remaining capital is distributed to other partners or GPs. Six to ten percent is the typical range for hurdles, with the split typically based on ownership percentages or factors stated in the legal offering’s documentation.
Many transactions are structured so that after the first hurdle, an 80/20 or similar split kicks in.
Key Terms for Preferred Returns
Preferred return hurdle (s): the percentage that must be reached before a capital-out event (refinance or sale) can occur or before allocations are made to LPs or GPs. These typically range from six to ten percent.
Preferred equity investment: is yet another preferred return variation. In a capital-out event, a preferred equity investor will get a return of capital, which includes a defined percentage return on their initial investment before any other investors receive funds.
Waterfalls: this preferred return structure lays out how returns are paid to various classes of investors in a REPE deal. The initial step of a waterfall is often the preferred return, which may be followed by many other steps that dictate how and when returns flow to specific investors, which gives rise to the waterfall analogy.
Cumulative or noncumulative preferred returns: cumulative means that the preferred returns unpaid in one period accumulate and are carried forward to the next period. For example, if in one year there isn't sufficient net cash flow to cover the preferred return, in which case, the outstanding preferred return may accumulate in the following period. This may occur because of an unanticipated capital expense, or for other reasons. Non-cumulative means that the preferred return is not carried forward and resets each period.
Compounded or non-compounded (simple) interest: compounded preferred returns encompass the amount of invested capital plus all the previously earned but unpaid amounts, while non-compounded means the preferred return only encompass the invested capital. Non-compounded interest is the norm, with only rare instances of compounded interest.
Pari-passu preferred returns: literally means equal footing in Latin. Pari-passu preferences dictate that the general partner, sponsor (if different from the GP), and all other capital partners are treated the same until a specific return has been reached for all. Depending on the deal’s structure, fresh capital flow rules apply and the GP/sponsor’s promotion takes effect for any remaining profit distribution above and beyond the preferred return threshold.
Catch-up provisions: describes a scenario in which the capital investor receives all the returns until a certain threshold or preferred return has been met. Thereafter, all investment returns go to the GP until a pre-determined threshold has been achieved. Relating a typical case, if the hurdle is 8 percent as described above, often this is followed by 9 and 10 percent that all goes to the GP, hence the term “catch up”, and this is often followed by a predetermined split of 80/20 or the like.
Looking-back provisions: only apply when a specified return has not been reached at the end of a period. At that point, the GP will usually sacrifice a portion of their returns to the capital/limited partners.
There is no industry standard for preferred returns in REPEs—not in terms of percentages nor in the manner return distributions and hurdles are structured.
It is the responsibility of the REPE’s investors to create a fair structure that all parties can accept. It should be noted that not all GPs even offer preferred returns to passive investors.
The REPE’s overall intent is to a secure optimum returns for passive investors. This frequently requires a level of creativity in crafting capital flows from a particular real estate syndication.
A preferred return offers a level of certainty to capital investors regarding the guaranteed rate of return on their money, plus other benefits, such as capital appreciation, refinancing, or outright sale scenarios.
This explains why REPE/syndicated real estate investments have a strong appeal to passive investors!