Why a Preferred Return Matters to the Passive Investor
A preferred return is a minimum return that a passive investor would receive before the operator gets any of their share of the cash flow or sale proceeds. Understanding how this metric works in real estate investments is key to putting the investor in a position to receive the highest returns.
In each syndication, the preferred return is established by an operator before the deal is presented to potential investors in the investment summary and operating agreement. Once a deal is in action, this preferred return must be paid out to the passive investors before the sponsor team can collect any revenue, reducing the overall investment risk. This aligns the interest between the passive investor and the operator. This puts passive investors at the forefront of the deal structure and incentivizes operators to produce as much revenue as possible for them to also make money on the deal. The operator will be focused on the time value of money (IRR) to execute the business plan and the overall lifespan of the investment to increase the overall return for both parties.
These passive investors are classified as class “A” shares and typically receive a preferred return from 6-9% on an annual basis. For example, if you invested $100,000 and the preferred return was 8%, then you would receive $8,000 in annual return of available cash flow.
What if you don’t hit a preferred return in the 1st year?
If there’s a point that investors are not paid the full % of their preferred return, they will accrue the deficit of the preferred return % and be paid the following year with the deficit % carried over. For example, if the preferred return was 8% but they only achieved 7% in that year, the following year, they would receive 9%. The sponsor would receive no distributions in that first year and the deficit is accrued and paid out immediately to the investors the next year. This is another reason why the preferred return reduces risk and provides a safety net on the investment.
This is a powerful tool to align investor and operator interests. It reduces the overall risk when investing in an offering as they will receive the first cash flow proceeds. Investors should seek out a sponsor who offers a preferred return in their favor and allow their money to work for them.