For some investors, the nuances of concepts like risk and return are not easily understood. Often, this is because someone investing in a project may not have an extensive background in finance or real estate.
This article will help new investors understand the concept of a preferred return and all of the details that can potentially arise when drawing up this type of agreement.
What is a Preferred Return?
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Before we can go any further in a discussion of how this type of return works, it is crucial to understand exactly what it is. Often, investors may not be familiar with all of the various permutations of this type of transaction, especially when it comes to how they work in real estate dealings. In addition, this should not be conflated with the term “preferred equity,” as these are not interchangeable.
In the simplest of terms, a preferred return, or “pref,” is a tool that allows joint venture partners to accurately measure a prenegotiated level of cash flow payment during a real estate transaction. By definition, it is a first claim on profits until the target return has been met. This means that preferred investors are the first ones to receive their agreed percentage of profits before the remainder of the money is distributed.
At its inception, this type of return was intended to have a twofold purpose.
First, it was meant to be a way for the sponsor of the transaction to reward a third-party investor for his cash investment.
Second, it was created as a way for the sponsor to signal to the investor that they are fully confident in the future success of their venture, so much so that they believe they can perform above and beyond the level of the pref.
How is This Type of Return Measured?
For most transactions, including commercial real estate ventures, the pref is generally based on a percentage. The important questions for an investor to ask, however, are how exactly the percentage is calculated and what specifically the return is a percentage of.
First, it is important to note that every commercial real estate partnership is different. There are no set or predefined agreement terms that investors are required to follow, so it is not uncommon to encounter a broad variety of conditions.
That being said, there are still some general agreement terms preferred investors need to know.
One issue investors will need to understand is whether the growth rate is compounded or non-compounded. This refers to the manner in which this particular return’s growth is calculated.
Another thing to consider is whether the growth rate will be cumulative or non-cumulative. Cumulative means that all of the cash earned within a period of time, but not paid out in that time frame, will be rolled forward into subsequent payout periods.
Finally, before reaching an agreement, it is important for investors to understand whose capital the return will be measured off of, as this can dramatically affect the end payouts.
Questions to Consider
Here are a few key pieces of information any investors should be sure to ask before reaching a binding agreement:
Preferred investors may be either all equity investors or just a select group. This varies per agreement.
– What is the compounding period?
If the pref is compounded, it is critical to clearly understand what the compounding frequency is. It could be monthly, daily, quarterly, annually or even continuous. Again, this is something that varies per investment, so be sure to clarify this beforehand.
– How will the investment balance be paid?
This goes back to the cumulative versus non-cumulative growth rate. This question is relevant because, in some cases, there may not be adequate cash flow to pay out the full return in a fiscal year. If the investment is cumulative, this will allow the unpaid balance to be rolled into the investment balance for the next period.
As investors seek to diversify their portfolios, participating in this type of agreement alongside various other levels of the capital stack will help to spread out risk while generating higher blended returns.
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