Real estate investment partnerships typically offer annual preferred returns between 6% and 9%. This structure will give critical protection to your capital investment. Your agreed-upon returns must be paid before sponsors can claim any profits, which creates a balanced relationship among all parties.
A preferred return stands as a cornerstone feature in real estate investment evaluation. Most partnerships set this threshold at 8%, which becomes the minimum return investors must receive before profit distribution to sponsors begins. These returns can follow a cumulative structure, so any shortfall from previous years carries forward. This additional layer of protection shields you from potential underperformance.
Knowledge of preferred returns and their role in distribution waterfalls helps protect your interests in real estate partnerships. Your overall returns can be substantially affected by the chosen calculation method – simple or compound interest. This becomes particularly relevant when early operating shortfalls occur. This piece explores preferred returns comprehensively to help you make smarter real estate investment choices.
What is a Preferred Return in Real Estate?
Preferred returns play a vital role in real estate investment structures by setting up priority rules for profit distribution. These returns give certain stakeholders the right to get their share of profits before others. This creates a threshold that sponsors must meet before they can share in the investment’s profits.
Definition and purpose
A preferred return—commonly known as “pref”—lets one group of equity holders receive profits before others until they hit a specific return rate. The rate usually runs between 6% to 10% each year, based on deal specifics and market conditions.
Preferred returns serve three main goals. They give investors first access to cash flow. They help investors and operators work together by making sponsors wait for their profit share (called “promote”). They also show that sponsors believe in the project’s success, which helps attract investors.
To cite an instance, see a deal with an 8% preferred return. If the property makes a 12% total return, investors get their 8% first. The remaining profits split according to a preset ratio like 70/30 or 80/20.
Preferred returns come in two types: cumulative and non-cumulative. Cumulative returns mean any missed targets roll over. Sponsors must pay these shortfalls before getting their share of future profits. Non-cumulative returns don’t carry forward missed targets from previous periods.
The way preferred returns get calculated can affect investor outcomes. They use either:
- Simple interest (based on contributed capital to date)
- Compound interest (based on contributed capital plus unpaid preferred return)
These calculation methods show big differences when early cash flow falls short.
How it differs from ROI or guaranteed returns
A preferred return isn’t actually a return on investment—it’s a threshold that determines how profits get shared. This difference matters a lot to investors.
Preferred returns are not the same as guaranteed payments or returns. They set up the order of profit distribution but don’t promise payments at specific times. The property’s cash flow determines when and how much gets distributed.
So if a property only makes 5% when the preferred return target is 7%, investors just get that 5%—not the full 7%. Investors should never think of preferred returns as guaranteed payments.
Many investors get confused about this point. Guaranteed returns promise specific payouts no matter what happens. Preferred returns just set up who gets paid first—they promise order, not payment.
The preferred return protects investors by making sure they get paid before sponsors receive performance fees. This setup pushes sponsors to make the property perform better than the preferred return target.
Preferred Return vs Preferred Equity
Real estate investors often confuse preferred returns with preferred equity. These concepts play different roles in investment structures. The difference becomes vital when you review investment opportunities and protect your capital.
Return on capital vs return of capital
The biggest difference between preferred returns and preferred equity comes down to getting a return on your capital or a return of your capital.
A preferred return sets the order of profit distribution—you get your percentage of profit before the sponsor takes their share. This represents a return on capital and shows how well a sponsor turns your equity into profits.
To cite an instance, see what happens when you invest $100,000 and receive $6,000 each year. Your return on capital equals 6%. This shows what your investment earns while keeping your original investment intact.
Preferred equity works differently. It decides who gets their principal investment back first when someone sells or refinances the property—this gives you a return of capital. You get your original investment back, either in parts or all at once.
Note that return of capital doesn’t count as income or capital gains for taxes. It just lowers your original investment balance. Put $100,000 in and get $6,000 back as return of capital in year one, and your investment drops to $94,000.
The way distributions work substantially affects your long-term returns. With return on capital, your syndicator pays based on your original investment. You’ll get the same amount each year (like $6,000 yearly on a $100,000 investment at 6%).
Return of capital distributions get smaller each year as your investment shrinks. Using our example, you’d get $6,000 in year one, $5,640 in year two (6% of $94,000), and $5,302 in year three (6% of $88,360).
Capital stack positioning explained
The capital stack helps you learn about risk and repayment order in real estate investments. Preferred equity sits below debt but above common equity in this hierarchy.
A capital stack shows you:
- Where you stand in cash flow distribution
- Your position’s risk level
- Whether your target return matches the risk
Preferred equity investors own property shares and get paid after debt payments. They usually receive a minimum return before lower-tier investors see any money.
Common equity holders, usually sponsors, take the highest risk—they get paid last, after all other positions receive their share.
The capital stack follows one basic rule: each source has priority over everything above it and ranks below everything under it. When someone sells or refinances, the bottom position gets paid first until fully settled, then moves up.
Risk grows as you climb the capital stack, but potential returns should grow too. During tough times, if there’s not enough money to pay everyone, losses start from the top. Common equity takes the first hit.
Passive investors who understand these differences can better review risks, expected returns, and distribution structures before investing. No position in the capital stack works best for everyone—each comes with its own risk-return profile that should line up with what you want from your investment.
Types of Preferred Returns Investors Should Know
Real estate partnerships come with several different preferred return structures. Each structure affects how your investment performs. These variations help you assess risks and rewards when looking at investment opportunities.
True preferred return
True preferred returns put investors at the front of the profit line, ahead of the sponsor. Your capital contributions get a safety net because you receive returns before the sponsor shares any profits. To cite an instance, an 8% true preferred return on a $100,000 investment means you get your $8,000 first. The sponsor can only share profits after that. Conservative investors find this structure appealing because it offers better protection.
Pari-passu preferred return
“Pari passu” comes from Latin and means “on equal footing”. This structure lets investors and sponsors receive preferred returns at the same time, based on their capital contributions. Everyone gets equal treatment until they reach the return threshold. The sponsor then receives a promote on additional returns. This setup creates a natural balance because all parties benefit equally from the initial returns.
Cumulative vs non-cumulative
The way unpaid returns get handled makes a big difference between preferred return structures:
- Cumulative preferred returns: Unpaid returns add up over time. The sponsor can’t share profits until these returns are paid. Investors get better protection because shortfalls carry forward until paid.
- Non-cumulative preferred returns: These returns don’t carry over from previous years. Investors lose any unpaid amounts from each period.
Real estate syndications usually use cumulative preferred returns. Investors like this option better because sponsors become more accountable for performance.
Simple vs compound interest
The way your preferred return gets calculated makes a huge difference in long-term results:
- Simple interest basis: A 10% annual preferred return that only pays 5% in year one means you’ll get the remaining 5% next year. The unpaid amount doesn’t add to your principal investment.
- Compound interest basis: Unpaid preferred returns become part of your capital account for future calculations. That unpaid 5% adds to your base and creates a snowball effect.
The compound approach can generate much higher returns, especially in projects that struggle with cash flow early on. This becomes a big deal as it means that longer-term investments with early cash flow challenges see dramatic differences.
These variations help you see what your real estate investments could really do. You can pick structures that match your investment goals and how much risk you want to take.
How Preferred Returns Fit into Real Estate Waterfall Structures
Real estate waterfall structures create a clear framework that distributes profits through preferred returns as their key component. These structures determine payment amounts, timing, and recipients throughout the investment lifecycle.
Simple preferred return calculation
The preferred return uses this formula: Contribution × (1+R)^(#Days/365). A $1 million investment made on December 31, 2020, with an 8% preferred return would earn $80,000 after one year.
The timing of these calculations matters. Some funds start accruing returns from the funding date. Others use the month’s last day. This small detail can affect your returns, particularly in long-term investments.
The calculation method—simple or compound interest—shapes your results. Compound interest adds unpaid preferred returns to your capital account. This creates a backlog the sponsor must clear before they can access profits.
Distribution order and tiers
Waterfall structures have four distinct tiers that allocate cash flows:
- Return of capital – Your original investment amount returns
- Preferred return – You get your minimum expected yield (typically 6-10%)
- Catch-up provision – Sponsor compensation
- Carried interest – Performance-based splits
Investment structures can arrange these tiers differently. Some return capital before paying preferred returns. Others prioritize preferred returns. Some agreements specify that Limited Partners receive distributions until they recover their capital contributions, then receive preferred returns.
Picture waterfall tiers as pools that fill one after another. Your preferred return “bucket” must fill up before excess cash moves down. Only then can the sponsor start receiving profits.
Catch-up provisions and promote structures
Limited Partners receive their preferred return first. Then catch-up provisions let General Partners receive accelerated distributions until they reach their agreed profit-sharing percentage. This bridges the gap between preferred returns and standard profit-splits.
Many investors misunderstand catch-up calculations. Take an $80,000 preferred return with a 20% GP catch-up. The math isn’t just 20% × $80,000 ($16,000). The actual formula is: [$80,000 preferred distribution / (100% – 20% GP catch-up)] × 20% = $20,000.
Promote structures become progressive as returns grow. A sponsor might get a 10% promote for returns between 8-12%, plus another 10% above 12%. Sponsors succeed only when investors do well, which encourages them to maximize property performance.
You can learn how these structures benefit your investment portfolio. Schedule a strategy call with Primior at https://primior.com/start/.
Real-World Example: How Preferred Returns Work in Practice
You’ll learn about preferred returns best by seeing how they work in real market conditions. Let’s look at a $100,000 investment with a 9% cumulative preferred return in a real estate syndication.
Year-by-year cash flow breakdown
Picture yourself investing in a value-add multifamily project. The property rarely performs exactly as projected:
- Year 1: Property gets only 5% cash flow ($5,000) against your 9% preferred return entitlement
- Year 2: Performance goes up to 7% ($7,000)
- Year 3: Cash flow hits 8% ($8,000)
- Year 4: Property refinances, yielding 18% ($18,000)
You receive all available cash distributions in years 1-3 because they stay below your preferred return threshold. Any shortfall adds up for future payment.
Effect of unpaid returns on future distributions
The total deficit reaches 7% by year 4 (4% + 2% + 1%). The refinancing distribution follows this order:
- Your 9% annual preferred return ($9,000)
- Your 7% cumulative makeup ($7,000)
- Remaining $2,000 splits by profit-sharing rules (typically 80/20), giving you $1,600 more
Compound preferred returns make this effect stronger over time. A 5% shortfall in year 1 on a $100,000 investment means the unpaid portion ($5,000) gets added to your capital account. Your preferred return in year 2 would calculate on $105,000 instead of just $100,000.
Risks and benefits for LPs and GPs
Limited partners get a vital safety buffer with first access to profits. This setup works best with value-add investments that might give uneven cash flows early on.
General partners do well when the project succeeds but struggle with mounting unpaid preferred returns. Too many unpaid preferred returns might reduce sponsors’ drive to maximize performance. Some deals include “catch-up” provisions that let the GP receive faster distributions once crossing the preferred return threshold.
Want to see how these structures could boost your investment portfolio? Schedule a strategy call with Primior at https://primior.com/start/.
Conclusion
Preferred returns are powerful tools that help real estate investors reduce their risk. You’ve seen how these structures—typically ranging from 6% to 9%—protect investors by setting clear payment priorities before sponsors can access profits.
Your investment outcomes depend heavily on how your preferred return structure works. The difference between cumulative and non-cumulative arrangements could put thousands more dollars in your pocket during market downturns or when properties underperform.
The way calculations happen makes a big difference too. Compound interest structures give you better benefits than simple interest approaches. This becomes clear when you look at year-by-year performance in ground examples, especially during long hold periods when cash flow is tight early on.
Preferred returns aren’t guaranteed payments, though they might seem that way. They simply promise who gets paid first—not when those payments will happen.
You should look closely at the waterfall structure around your preferred return. Four-tier structures usually strike the right balance between protecting investors and keeping sponsors motivated. Both parties need the right incentives at each level to make the deal work.
Smart investors know that preferred returns help arrange everyone’s interests. Sponsors must perform above the preferred return threshold to access their promote, which pushes them to maximize property performance.
Read the operating agreement carefully before putting money into any real estate partnership. Know exactly how preferred returns work and get distributed. This protects your interests and helps set the right expectations from day one.
Preferred returns are just one part of a detailed real estate investment strategy. Notwithstanding that, they give you essential protection while keeping your upside potential—exactly what savvy investors want in today’s market.
To find how preferred return structures can work best for your investment portfolio, schedule a strategy call with Primior through https://primior.com/start/.
