What is a Preferred Return?

Our most recent deal, which offers preferred returns to investors, has sparked numerous inquiries given that this type of offering is unheard of in the current market. For those new to multifamily syndication, there has been confusion surrounding the concept of preferred returns, with some mistakenly equating it to the total return of the deal. We want to clarify the definition and significance of preferred returns in our investment framework, providing you with the necessary information to make informed decisions and invest with confidence.

Question One: What is a Preferred Return?

A preferred return is a profit distribution preference whereby profits, either from operations, sale, or refinance, are distributed to one class of equity before another until a certain rate of return on the initial investment is reached.  The pref is stated as a percentage, such as an 6% cumulative return on initial investment; however, it can also be stated as a certain equity multiple.  This preference provides some comfort to investors since it comes before the sponsor’s profits participation up to a certain return threshold.

Preferred Return v. Preferred Equity

The preferred return is distinct from the idea of “preferred equity,” which is a position in the capital stack that has a repayment priority.  The difference lies in the return on and return of capital.  The preferred return is a preference in the returns on capital, while a preferred equity position is one that receives a preference in the return of capital.  In most true preferred equity investments, investors get their initial investment and also get a set percentage return on their investment before the subordinate equity investor gets even $1 dollar of cash flow.  If the investor does not receive a return of capital before the sponsor or some other equity tranche, then the investor is in a “common” or “JV equity” position and not a preferred equity position.

Our latest opportunity- The Cape, is a Common Equity with a True Pref deal. Explained in the second example below.

The True v. Pari Passu Preferred Return

An investor in a common equity position can still receive a pref, and the type of pref can be further distinguished based on the treatment of sponsor capital, called the co-investment.  If the investor receives a preferred return (i.e. profits) before a sponsor does, then the pref is a “true” preferred return; however, if the investor and the sponsor receive the same preferred return, paid at the same time, then pref is a “pari-passu preferred return.” With a true pref, the investor receives preferential treatment on its capital contribution; with a pari-passu pref, the investor does not.  Instead, the pari-passu pref acts as a threshold up to which investor and sponsor capital are treated equally and over which the sponsor capital receives a promote.

To help clarify these concepts, consider the following examples.  The returns in these examples are for illustrative purposes only and not necessarily indicative of prevailing market rates.

Preferred Equity

In this example of preferred equity, the investors first receive their capital contributions plus a 12% annualized return before then sponsor receives any money. Second, the sponsor receives its capital contribution.  Finally, investors receive 0% of all excess profits with the sponsor receiving 100% of all excess profits. The investors receive a true preferred return rate and, in exchange, do not participate in the upside after exit as they receive none of profits over their 12% true preferred return.  Overall, the return is likely to be lower than if they participated in the upside in a JV equity position; however, their overall investment risk is lower.

Common Equity with a True Pref

In this example of a common equity investment with a true pref, the investors receive a 6% annualized return before then sponsor receives any money.  The difference is that the sponsor receives a return of capital pro rata with the investors.  Above the 6% investor pref, investors and sponsor divide excess profits 80% / 20% respectively.  The investors likely receive a lower pref, in comparison to a pari-passu pref, because it is a true pref. Overall, the return is higher because they will participate in the upside. See the illustration below.

1. First, 100% of all cash inflows to the LP until the cumulative distributions equal the original capital invested.
2. Second, 100% of all cash inflows to the LP until the LP has received a preferred return on the capital invested in step 1.  
3. Third, a "20% catch-up" to the GP equivalent to 20% of the distributions realized in step 2 plus the distributions realized in this step. 
4. Fourth, thereafter, cash flows in excess of distributions made in step 1, 2 and 3 (if any) are distributed 80% to the LP and 20% to the GP.

Common Equity with a Pari-Passu Pref

In this example of a common equity investment with a pari-passu pref, the investors and sponsor each receive an 8% annualized return on their investments and return of capital, pro-rata.  Above the 8% pari-passu pref, investors and sponsor divide excess profits 75% / 25% respectively.  In this case, investors DO NOT receive any profits before the sponsor does.  The pari-passu pref allows the sponsor to receive cash flow alongside the investors during the investment period.  The investors’ repayment risk is higher, but they also share in more of the profits.  In this scenario, the investors are treated as equal to the sponsor until the pref is paid and capital is returned. Beyond that point, the sponsor earns a disproportionate share of additional profits via its promote.

Simple v. Cumulative Pref

The final item of note is that the pref is not always calculated in the same way.  Sometimes, the sponsor calculates the pref on a simple interest basis.  The alternative is a compounding basis.  Supposed that an investor is entitled to a 10% annual pref, but that in the first year, there is only enough profit to pay a 5% return.  In the second year, cash flow ramps substantially and pays a 15% return. In the simple interest basis, the additional 5% would still be owed next year but not added to the initial balance. In the compounding basis, the outstanding 5% would be added to the investor’s capital account for purposes of calculating the next years preferred return.  This example is shown below.

Non-compounding

Notice in the compounding example, even the ramped-up 15% return did not satisfy the accumulated return owed.  It fell short by $500, which would then be compounded into the pref accrued for Year 3.  Over time, the compounded pref can generate substantially greater returns in the case of operating shortfalls in earlier years.

Question Two: What is Annualized Average Return?

In multifamily real estate syndications, many investors frequently fail to assess their return on investment holistically, emphasizing cash flow returns while overlooking the overall profitability of the venture.

The total annualized return (also called Holding Period Return/Yield) in a multifamily real estate syndication can vary widely and depends on factors such as property performance, market conditions, and the specific terms of the syndication. It typically includes both cash flow and appreciation of the property value over time.

The overall average annualized return in a multifamily real estate syndication can be calculated using the following formula:

Average Annualized Return = (Total Future Value / Total Investment)^{1/Hold Period} − 1

• Total Future Value = total value of the investment at the end of the hold period, including both the initial investment and any profits.
• Total Investment = total amount of capital invested.
• Hold Period = number of years the investment is held.

This formula considers the compounded annual growth rate (CAGR) over the hold period and provides a standardized measure for evaluating the overall performance of the syndication.

Question Three: Stocks vs Multifamily Real Estate?

Let's put this into perspective, the average annualized return of the S&P500 is 10.13%. Adjusted for inflation, the historical average annual return is only around 6.29%. Our latest opportunity is projected to deliver a conservative 20.04% annualized average return (Class A investors) within a 5-year hold period.

While the S&P 500 (and stocks generally) remains a solid choice for many, our team's proven track record in multifamily real estate offers a compelling choice for portfolio diversification, having consistently delivered outstanding results in previous ventures.