Offering a preferred return (or “hurdle rate”) continues to grow in popularity.
As an investor, it’s very likely you’ve encountered this term at some point. You may, however, be unfamiliar with what it means for your investment and the subtle differences between the various types.
So, what is it and what does it mean for your investment?
By definition, a preferred return refers to the threshold return that the limited partners (LP) must receive before the general partners (GP) receive payment.
Traditionally, this is expressed as a percentage return per year. Once the hurdle rate has been achieved, the profits will be split between the LPs and the GPs on a predetermined ratio (sometimes referred to as the “split”).
Preferred Return vs Preferred Equity
Preferred return is not preferred equity, and this distinction is important for your investment.
A preferred return is a preference in the return ON your capital investment. In contrast, preferred equity is a preference in the return OF your capital investment.
Preferred equity sits behind the debt in the capital stack, and investors get their initial investment and set return before any other investors receive a penny.
Preferred equity is similar to an unsecured loan. The lender (investors) receive payments at a fixed rate, and the original capital balance is returned over time and at sale. Much like a lender, preferred equity does not participate in the upside in the property.
Common Equity Investors
Common Equity investors can receive a preferred return, but it can be treated in different ways.
For a “true” preferred return, investors receive profits up to a set percentage before the sponsors get anything.
However, there are instances where both the sponsors and investors receive the preferred return at the same time, in such cases this is referred to as a Pari Passu return.
Fun fact, Pari Passu is French for “on equal footing.” I bet you didn’t think you’d be learning French!
How it is Calculated: Compounded, Cumulative, or Neither
Surprise, there are also different ways in which it can be calculated. The most common are compounded and cumulative.
Compounded means both the unpaid owed distributions and capital account balance are subject to the hurdle rate.
Non-compounded means that only the non-returned capital balance is used in calculations.
Cumulative means that all the money earned in one period, typically annually, that has not been paid out in distributions will be carried forward to the next period. This can also be referred to as an investor “catch-up.”
This is common in investments where the yearly cash flow is typically below the 6-10% hurdle rate. Investors in these projects are “caught up” at disposition.
Non-cumulative means just that, if the return is not paid out in that period, it is not rolled forward into the next.
Wrapping it Up: Why is a Preferred Return Important?
A preferred return is a great way of making sure investor and sponsor interests are aligned. It assures investors that they will receive a set return before the sponsor, and that the sponsor is confident they will reach and surpass the hurdle rate.
Knowing how it is calculated and handled is vital for your investment, be sure to clarify with your sponsor or investors before making any investment decisions.
Jay Helms is a real estate investor and host of the W2 Capitalist Real Estate Podcast...
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