Commercial Real Estate (CRE) Investor Question #83: What is Preferred Return and does it matter?
Preferred return is part of a distribution waterfall in real estate private equity. We’ve seen earlier that a Distribution Waterfall refers to the way in which profits are allocated between the participants – sponsors and Limited Partners – in an investment.
Preferred return is a key component of the distribution waterfall and its main purpose is to align incentives between the sponsor and limited partners(LPs). Let us take an example from EquityMultiple, a popular funding website:
In this arrangement, the investor will receive a preferred return before any capital is returned to the sponsor; the investor will receive profits up to a predefined percentage rate of return. Let’s look at our Bushwick Mixed-Use Redevelopment Project. The order of profit distribution is as follows:
1) 100% pro rata to investors (including the Sponsor and LPs) until they have received a cumulative 10% preferred return
2) Return of investor capital contributions, pro rata
3) 30% to the sponsor and 70% to investors (including the Sponsor, such that the Sponsor receives a share of the 70% in addition to their 30%)
Source: https://www.equitymultiple.com/blog/commercial-real-estate-practice/preferred-return
Preferred return aligns the sponsor to the LPs i.e. the sponsors won’t get any extra profit until a certain threshold is met. In the above example, both sponsors and LPs will equally share the profits until 10%. After that sponsors, will take an extra percentage of the profits (also called promote) which can be an incentive for them to perform better. For LPs, preferred return is always better than no preferred return for a given a deal, all other parameters being the same.