I very often get asked to look at deals on behalf of investors. And I’ll very often get a comment like this: “I think it is a good deal because the operator is offering me a 10% preferred return!” It is understandable why an investor would say something like this, but there are clearly two misunderstandings at play.
The first misunderstanding relates to what a preferred return is. In the typical real estate transaction, preferred returns are offered to investors to ensure they receive a return on their capital BEFORE the operator of the deal (deal sponsor) takes a promoted interest (a promoted interest is an excess share of profits that deal sponsors are rewarded with in the event a deal performs well).
A preferred return is NOT guaranteed minimum interest payment. Just because a deal consists of a preferred return, it does not mean the operator is committing to distributing that money (say 10% annually) to their investors.
In the current investment climate, you’d be hard-pressed to find a transaction in which the year 1 annualized returns are 10%. It’s usually not even possible for a sponsor to commit to distributing 10%, as the underlying asset is simply not producing that much cashflow.
The preferred return (or “pref” colloquially) simply represents the fact that the sponsor will not take their excess profits until the investor receives:
- all of their capital back
- a 10% IRR on their capital (assuming the preferred return is 10%).
Then, once the investor has received those two things, could the sponsor start to take their promoted interest.
In general, sponsors will make distributions as they have the capital available. Preferred returns are often paid only when the investment is exited, in year 3-10. If the preferred return was not paid through cashflows during the life of the investment, it accrues (and compounds), and is paid at a later date when a capital event occurs.
The upshot of all of this is that you can never use the preferred return as a gauge for the quality of the transaction. Good transactions are built on solid deal-level fundamentals. In the above example, the investor thought the deal was good because the sponsor was offering a high pref. But the pref won’t matter if the deal does not make money. And the sponsor is not on the hook to pay any investor a pref if the deal does not perform.