Preferred Returns in Private Equity and Real Estate

Key Takeaways 

• Most commonly used in private equity, a preferred return is the claim on profits that goes to a project’s preferred investors.

• If a preferred return is received by an investor over a sponsor, that return is deemed a true preferred return.

• An investor in preferred equity gets back their initial investment, in addition to an established percentage return on investment, before other investors receive anything.

It is important for investors, particularly those in private equity and real estate, to understand preferred returns. After all, such returns have a role in rewarding early or substantial investors, exhibiting confidence in profitability, and aligning the interests of investors and sponsors.

Here is all about the structure, benefits, and risks related to preferred returns.

What is Preferred Return?

Most commonly associated with private equity, such as real estate investment, a preferred return is the claim on profits that goes to a project’s preferred investors. It is essentially a profit distribution preference, a way to reward early investors. In addition, preferred return is a way to express confidence in profitability, and thus to lure other investors

With preferred return, often shortened to “pref,” profits are distributed to a succession of equity classes until a specific return rate is reached on the original investment.

Stated as a percentage or equity multiple, preferred return is often favored by investors since the sponsor’s “promote” or profits participation is subordinated up to a specific return threshold, generally 8 to 10 percent.

In other words, a fund’s general partner (GP) may not share in profits until the minimum return a fund must achieve for limited partners is reached. The preferred return, or hurdle rate, is set by GPs and is included in offering documents.

In real estate transactions, preferred return is key in that it aligns investors’ and operators’ interests in private equity and real estate transactions.

Preferred Return v. Preferred Equity 

Preferred return is not to be confused with preferred equity, in that the former refers to a preference in capital investment returns. Those with a preferred equity position get a preference in the return of their original capital investment.

An investor in preferred equity gets back their initial investment, in addition to an established percentage return on investment, before other investors receive anything.

A common practice in preferred return is to structure the investment so that, once a certain minimum return is achieved, the general partner gets a favorably disproportionate cash-flow split. A key element In preferred equity structure is the establishment of a senior capital stack equity position regarding the return of capital to the joint venture.

The True v. Pari Passu Preferred Return

Those with a common equity position can receive a preferred return, the type of which depends upon how sponsor capital is treated. 

If a preferred return is received by an investor over a sponsor, that return is deemed a true preferred return. If the return is received by the investor and sponsor simultaneously, it is called a Pari-Passu preferred return.

With a Pari-Passu, the investor gets no preferential treatment on their capital contribution. Rather, it serves as a parameter in which the sponsor’s and investor’s strategy are treated equally. The sponsor is rewarded once those parameters are exceeded.

In commercial real estate, Pari-Passu refers to two investors and sponsors that are on equal footings — neither is weighted more than the other. It is most often used to describe the manner in which investors are to get payouts.

Simple v. Cumulative Preferred Return

When it comes to how to calculate preferred returns, that can vary. Such returns can be calculated by the sponsor on either a simple interest or compounding basis.

Say an investor is due a 10 percent yearly preferred return, but there is only enough first-year profit to pay 5 percent. In that case, the return will be increased in the second year to 15 percent.

If a simple interest basis is used, an additional 5 percent would be owed but not added to the original balance. With the compounding basis, the 5 percent owed is added to the investor’s capital account. In turn, the amount will be used to calculate the following year’s preferred return.

How is the Preferred Return Calculated?

How to calculate preferred returns? That depends on the funds and whether the return is compounded or non-compounded, cumulative, or non-cumulative, and whose capital is measured.

With compounded returns, the preferred return growth amount calculation derives from the invested capital amount. That is in addition to previously earned but unpaid totals.

If preferred returns are cumulative, it means that all monies earned in a period that are not paid out at that period’s conclusion are rolled over to the next period.

Regarding whose capital is measured, that is up to investors, as there is no single structure all investors use. It is advisable to determine what works best for investors, then clearly delineate how their return on investment will be calculated.

In an example of a preferred return calculation, if the hurdle is 8% and investors contribute $1 million, the annual return rate totals $80,000.

Note the implications of using a return of capital strategy, however. Such an approach refers to the part of an investment’s distribution that is considered the investor’s original capital — not income. 

Say an investor purchases 100 shares of ABC stock at $20 each. A subsequent 2-for-1 stock split adjusts the holdings to 200 shares at $10 each. If the shares are sold for $15 each, the first $10 is not taxed because of its consideration as a return of capital. As a capital gain, an additional $5 goes on the personal tax return.

However, the approach does lower the investment balance. For instance, if someone invests $10,000 and gets $6,000 in the first year, the investment balance drops to $94,000.

When the investment is sold, then, the distribution is not taxed in the year received. However, the investor’s adjusted cost basis is affected, which can impact preferred return obligations.

Caveats and Exceptions

A real estate syndication refers to a partnership among investors who are pooling their resources to form a single investment. 

There are certain terms that pertain to syndication structures that are unique regarding preferred returns, including the “catch-up” provision. Under that condition, investors are due 100% of all profit distributions until the predetermined rate of return as per the agreement is met.

Then there is the term “non-cumulative preferred return.” For example, if the non-cumulative preferred return was pegged at 8 percent, 100 percent of distributable cash goes first to investors. However, if the return did not reach 8 percent in a given year, there would be a new start next year. At that time, there will be no arrearages due.

Why is the Preferred Return Important for Investors?

Early investors or those who make a relatively large contribution may be rewarded through preferred return.

Such a return is also a way to express confidence to investors that the pledged return will not only be reached — but exceeded. Sponsors are incentivized to maximize real estate profits and build on such confidence to attract other investors.

In general, real estate remains a popular investment. After all, potential benefits include cash flow, tax favorability, value appreciation, and a shield against inflation.

There are a number of ways to participate in the market, including through one of the leading alternative investment platforms Willow Wealth.

The platform, which makes such investing easy and accessible, includes commercial real estate (CRE) among its broad selection of opportunities. Such private-market offerings, meant to generate consistent secondary income, are generally less volatile. That is due to their low correlation to fluctuating public markets.

Willow Wealth’s real estate offerings can potentially offer steady returns with just a $10,000 minimum. Note that some REIT dividends are considered a return of capital, in that invested funds are returned. 

So far, the company has closed over $900 million in CRE transactions on 100 deals. For IRA investors, the platform also has a real estate equity program.

Investing in real estate also serves another essential purpose: investment diversification. Building a more modern portfolio of varying asset types and expected returns can help mitigate overall risk, and potentially improve returns.

Alternative investments and Portfolio Diversification 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, platforms like Willow Wealth provide curated access to private markets for individual investors.   

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.  

Join more than 500,000 members and start investing in private markets today at willowwealth.com. 

Summary

Preferred returns have an important role in private equity and real estate investments, in that they shape investor risks, rewards, and partnerships. Note, too, their importance in lining up investors’ and operators’ interests in PE and property deals.