Question from one of our readers: What is a preferred return?
Answer: At its most basic, a preferred return (“pref”) is a mechanism for measuring a negotiated level of cash flow payment due to one or both of two equity joint venture partners in a real estate transaction.
The preferred return originated as a way for the transaction’s sponsor to:
a) reward the third party cash investor in a transaction for the latter’s majority cash investment, and
b) signal to the investor that they as sponsor feel that the transaction’s performance will not only achieve, but also exceed, the level of the preferred return.
This brings us to a key nuance: How is the preferred return being measured, and who is receiving the preferred return?
Preferred returns are typically percentage-based (e.g., “an 8% annual preferred return”), but the operative questions are: percentage of what? measured and calculated how?
- All cash investors in a commercial real estate transaction want to be rewarded based on (at a minimum) the total dollar amount they invest
- The sponsor and the third party investor will typically invest different dollar amounts, with the third party investor contributing the large majority of the capital
So let’s say the joint venture (“JV”) partnership operating agreement for this transaction includes an 8% annual preferred return. One needs to know the nature of that 8% growth rate on the capital invested, namely:
- is it non-compounded or compounded (compounded meaning the preferred return periodic growth amount (the interest “accrual”) is calculated off of the invested capital account balance plus all previously earned but unpaid accrual amounts)?, and
- is it non-cumulative or cumulative (cumulative meaning all dollars earned in a period that are not paid out at the end of that period are carried forward to the subsequent period)?, and
- off of whose capital is the preferred return measured?
The unlocked, downloadable Excel-based example embedded below shows a non-compounded, cumulative annually-calculated return with annual payment, with the return measured off of the performance of the third party investor’s capital only. Note that there is a toggle in row 10 that allows you to choose which party or parties participate in the preferred return. This addresses the more recent development in joint venture partnership structures in which the sponsor also benefits from the preferred return. The sponsor getting the preferred return seems like a contradiction to the spirit and original purpose, but alas, strong sponsors have been able to make this a reality in the JV landscape.
The unlocked, downloadable Excel-based example embedded below shows a compounded, cumulative annually-calculated return with annual payment, also with the return measured off of the performance of the third party investor’s capital only.
Valuate does all of this efficiently and beautifully without risking any miscalculations.
If you want to learn more about the mechanics in Excel, we also have this self-study video tutorial on partnership modeling.
From an Investor point of view the preferred return is an opportunity cost. What are my alternative vehicles that would generate a similar return? Usually real estate offers an Investor a chance at higher overall returns not necessarily because real estate is more risky but because it is an illiquid investment with longer time horizons.
From a Sponsor point of view the difference between an 8% and 10% preferred return shouldn’t mean much since in most deals an “event” (refi or sale) needs to happen in order to return the initial investment and payoff the accrued “pref” to the Partnership – the successive tiers in the waterfall really provide the Sponsor with the greatest percentage share of the backend profits and splits become more favorable.
Ultimately the strength of the capital markets will also determine who will have the upper hand in the constant tug-of-war battle between Sponsor and Investor and structuring the joint-venture.
Question. Do you “book” the accrued preferred return on equity each year as effectively appropriated retained earnings if it is not a guaranteed payment type of situation? Just looking for the proper accounting treatment on accrued but unpaid preferred returns for an LLC (treated as a partnership)