When investing in real estate properties, you will likely come across the term “preferred return” (a.k.a.,pref).
While the term is used to refer to many types of investments, investors who are new to the real estate world may not fully understand what the different pref structures are, how it relates to their asset, or which structure works best for them.
Essentially, pref in real estate refers to a method of distributing profits created from the operations, sale, or refinancing of a real estate investment to the equity stakeholders involved—the sponsor and the investors.
In a pref distribution scenario, the profits are distributed first to one equity class before the others until a certain rate of return on the initial investment is reached.
Prefs can be stated as a percentage of the cumulative return on the initial investment or as a multiple of the equity contribution.
Investors generally like prefs because they limit the sponsor’s profit participation (also called the “promote”) up to a certain point and allow investors to enjoy returns earlier in the life cycle of the investment.
Different Types of Pref
There are different types of pref in real estate investments.
In a “true” pref, the investor receives returns before the sponsor does.
However, the percentage of returns the investor receives at that time is smaller with a true pref than with a “pari passu” pref, where the sponsor’s capital is treated the same as the investor’s capital.
Also, prefs can be calculated on either a simple interest or compounding interest basis.
In the former, returns that could not be paid during one year are paid in the following year; in the latter, any returns owed from the previous year are added to the investor’s capital account in order to calculate the next year’s preferred return.
When there are operating shortfalls early in an investment’s life cycle, choosing compounded pref can ultimately generate significantly greater returns.
Another structural option is preferred equity.
While their definitions sound similar, preferred return is a preference in the way returns are paid out, while preferred equity is a preference in the investor’s position in the capital stack and the order in which returns are paid out.
In most preferred equity scenarios, an equity investor would receive his or her initial investment and a predetermined percentage of the returns before the sponsor or developer receives any cash-flow payment.
Without this arrangement, the investor would be in a common or JV equity scenario rather than a preferred equity one.
Preferred equity does not receive a share of the profits in real estate transactions, is subordinate to debt, and is not treated as a lender.
But, as members of the LLC controlling the real estate, preferred equity holders can take over control of the LLC in the event of default.
In determining which pref structure works best for you, it makes sense to call in a real estate investment professional who understands prefs, how they relate to your transaction, and your investment goals.
Focusing on education and expertise in prefs will help you get the most out of your investment.
Related: What is Fund II?