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Money makes the world go ’round. And capitalism creates the opportunity for an individual to make large capital gains over varying rates of time. That could mean thousands of dollars in a month, in an hour of working or even without working at all — there are individuals who invest in apartments passively, without spending any time working. Wouldn’t it be nice to comfortably sit at the front of the line to receive the first payout, too?
This is what’s known as a preferred return. Not only does the investor receive distributions from the revenue generated by the property, but they can also ensure their return with a high level of confidence when it’s paid out as a preferred return. This essentially puts them at the front of the line when it comes to paydays.
What Is A Preferred Return?
A preferred return is a predetermined percentage that must be paid to the investor before the sponsor collects any of the distribution money. After the preferred return is paid, any remaining money above that percentage is split between the investor and sponsor at a predetermined ratio. With this structure, the sponsor is incentivized to make the property produce as much money as possible.
Preferred return is also accrued. This means that if the sponsor hits a month where the expenses are unusually high (during renovations) and the preferred return is not distributed, then the percentage in deficit is accrued and rolls over to be paid out on top of the distributions for the following year. The investor would receive all the distributions and the sponsor would receive zero.
Why Investors Prefer A Preferred Return
The structure of a preferred return favors the investor in times of scarcity. If there’s ever a time when the first in line isn’t paid the full percentage, the second in line receives zero, and the first in line accrues that percentage and is paid first in the following year along with the previous year’s deficit before the second in line receives a penny. This structure is very attractive for investors because they receive the first predetermined percentage and then a split of any money after that.
Let’s dive into a real-life scenario.
Examples Of Preferred Return
A preferred return of 8% means the first 8% of distributions must first be paid to the investor, and any distributions above the 8% follows a split or waterfall as dictated by the operating agreement (be sure to always read this agreement very closely). For this example, we will call it a 75/25 split. This means that after the 8% preferred return has been paid, the remainder is split 75% to the investor and 25% to the sponsor.
Let’s break this down even further into three scenarios, in which the investment returns 6%, 8% and 15%.
Scenario 1: At 6%, the sponsor did not hit the preferred return of 8%, so the entirety of the 6% goes toward the investor with preferred return. There is a deficit of 2% which is accrued and must be paid out the following year. In year 2, the investor will receive the usual 8% plus the 2% from year one (totaling 10%) before the sponsor can take any percentage whatsoever. In this scenario, the sponsor receives 0%. You can see why the sponsor must be highly motivated to make the property perform well above the preferred return percentage.
Scenario 2: At 8%, the sponsor has fully achieved the preferred return of 8%, and all of it goes to the investor to pay the preferred return. In this scenario, there is not a deficit, so nothing is accrued or carried over into year two. But there is also no meat left on the bone after the 8%, so the sponsor doesn’t receive any of the distributions. This again incentivizes the sponsor to make sure the property is performing well above the preferred return percentage; otherwise, the sponsor doesn’t get paid.
Scenario 3: At 15%, the sponsor has achieved and exceeded the preferred return, and the first 8% goes to the investor. Now there is a 7% remainder after paying out the 8% preferred return. The remainder is split 75/25, meaning 75% of the remainder goes to the investor, and 25% goes to the sponsor. Out of the three scenarios given, this is the only scenario where the sponsor receives distributions. The reason for this is because the sponsor should only get paid if the property is producing enough gross revenue from rents, minimizing expenses and creating a large enough positive net operating income to substantiate the debt payment and then pay out distributions. After paying out the preferred return of 8%, the sponsor will then receive only 25% of any meat left on the bone.
Put Your Money Where Your Mouth Is
The most common roadblock to avoid is analysis paralysis. In my opinion, the biggest mistake in apartment investing is to never take action. Understand how a preferred return works, and find a sponsor with a strong preferred return (for example, 8%) and an investor-favored split after achieving the preferred return. Consider how strong the return is and the confidence that is instilled when investing $100,000 with a preferred 8% annual return ($8,000 per year), and then on top of that, the investor also receives 75% of any distributions above the 8%. In the 15% example above, the remainder after the preferred return would be $7,000, and the investor would receive 75% of that ($5,250). Add that to the $8,000 preferred return, and it equals $13,250 in one year on a $100,000 investment. Very strong returns on a solid investment.
This reminds me of a famous quote by James W. Frick that emphasizes the importance of where you put your money: “Don’t tell me where your priorities are. Show me where you spend your money, and I’ll tell you what they are.”