Preferred Return

Investors with preferred shares or preferred returns receive distributions and returns up to an agreed upon percentage before the sponsor. This holds them accountable and ensures interests are aligned.

What is a preferred return?‍

A preferred return is a pre-decided percentage of return that a preferred investor will receive from the profits before the sponsor or the investment management team can receive a profit. This percentage is typically maintained between 6% - 9%, depending on the risk, however, the percentage can be higher or lower as decided by the parties involved in the transaction. 

Once the preferred return amount is given to the preferred investors, the excess profit can be shared amongst other investors and the sponsor. A preferred return is categorized as annual rate of return and can be considered as the minimum rate of return on the investment. 

It is absolutely essential for sponsors or real estate managers to foresee the profitability of a new real estate project and determine the ROI based on various factors such as the market trend, occupancy rate, vacancy rate, etc. The investors can only be paid back if the project succeeds to generate large profit and this is what the real estate managers ensure. 

Why is preferred return important for real estate investors?‍

Preferred return is an important way to incentivize investors who were the first ones to invest a large amount of money for the real estate project. This allows them to negotiate a return on investment that justifies their share of money. It is important because it gives early investors a higher share in profit and also because it brings in a good amount of money for the project owner or sponsor to raise capital. 

It is important to understand the concept of preferred return so that investors can achieve maximum profits from their investment amount. 

Can preferred return be accrued?‍

Preferred return is also accrued which means that if the project does not perform as per expectations and the profits are lower than what they should have been, then the investors are paid only a part of the preferred return. The remaining percentage is accrued and paid along with the next year’s return. 

Sometimes, when the expenses are unusually high the project is not able to make as much profit as it should have. In this case, if the profits are low, the preferred investors are paid first even if it means there is none left for the sponsor. 

What is an example of preferred return?‍

To understand the preferred return better, let us take an example.

Let’s say that there is a new project which has a preferred return rate of 9%. This means that at the time of distributions, the preferred investors will get 9% of the distributions and any remaining distributions above 9% will be split amongst the investors and the sponsor as per the agreed upon terms. 

This split can be anything, but most commonly it is set at 75/25, wherein, 75% of the remaining distribution will go to the investors and 25% will go to the sponsor. In this example, after the 9% preferred return is given, the remaining profit is split at 75/25 ratio if this is the agreed upon deal. 

In this example, if the sponsor is unable to generate optimal profits and can only provide 8% instead of 9%, then this deficit is accrued and the sponsor is liable to pay an additional 1% of the distributions the next year to the investor on top of the agreed 9%. ‍

Conclusion‍

Preferred return is important for both the investor, sponsor and real estate managers to ensure they are getting the maximum profits from their investment. When the sponsor is obligated to ensure that everything runs smoothly in order to generate high profits, the investor also gets maximized returns on top of his agreed preferred return. Due to this, the investors are also secured under conditions when the market is down and the real estate property is unable to generate a lot of profit as whatever amount is generated, the preferred investor is paid off first. 

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