What is a preferred return and how does it work?

As an investor, it is important to know the key components of a deal when evaluating syndications. In this video, we cover preferred returns specifically. Three crucial things you want to find out are: 

1.    Is there a preferred return?
2.    What is the percentage for the preferred return?
3.    What is the split between the general partners and limited partners on the preferred return?

Before you can understand these and what they mean to you as an investor, you must first understand what a preferred return is and the role it plays in the structure of the syndication.

 What is a preferred return?

‍A preferred return is a guaranteed minimum return that an investor receives before any profits are split with the management team. The percentage for the preferred return can vary depending on the deal, however, 6-9% is typical. It can also fluctuate between different investors within a deal, such as offering a higher preferred return to those who invest a larger amount.  

So, what does that mean? Distributions are first and foremost paid out to the investors until they have met the preferred return percentage. Once that threshold is met, any further returns are split amongst the investors and general partners according to the structure of the deal, typically with 70% going to limited partners (investors) and 30% going to general partners. This remains from day one through the life of the deal, often with monthly or quarterly distribution payments to investors. 

In the case that a deal has a shortfall in cash flow and the annual returns for any given year don’t allow for preferred returns to be paid out in full, the amount owed accrues throughout the life of the deal. In this case, the management company is required to make up what is owed to investors for the preferred return before any additional moneys can be split. 

‍Example of a preferred return 

‍For example, if you were to invest $100,000 in a real estate syndication with a 7% preferred return, you would receive $7,000 on your investment each year. Let’s say occupancy rates were low during the first year and you were only able to be paid out $5,000 because of a shortfall in cash flow. You would then be entitled to $9,000 the following year to make up for the difference owed to you from the previous year so long as there was the funds to do so. In the case that there were not sufficient funds to make the amount up, it would continue to accrue.

‍Why are preferred returns important to investors?

‍Preferred returns are definitely something to pay attention to as an investor, as it is essentially ensuring that you will receive your share of the proceeds first. This not only protects you and your investment but also incentivizes the management team to perform since they are not paid until that return is met. Learn how we break down our deal structure at Smart Wealth Equity.

Want to learn more about a different way to invest in real estate? Download our FREE Passive Investor's Guide to Multifamily Syndications and begin your path to financial freedom!