Many people are interested in getting involved with real estate investing, but they don’t have the time to be an active, full-time landlord. Most people want monthly cash flow, tax advantages through deduction and depreciation, and the potential for financial freedom and early retirement. The thing that trips would-be passive investors up is the lack of transparency in this industry.
A big point of confusion is how passive investors are compensated in a real estate syndication. One of the most important vehicles for investor compensation in a syndication is what is known as a preferred return. For those of you who are unfamiliar with real estate syndications, we’ll first give a brief overview of that topic.
Real Estate Syndications are Crowdfunded Investments
As I’ve said before in other writings, it wasn’t until the passage of the JOBS Act in 2012 that passive real estate investing entered the public consciousness.
Through what is known as a real estate syndication, a group of investors work together to purchase much larger assets, for example a 150 unit apartment building, than any individual investor could afford to purchase on their own.
The way it works is a group of full time real estate professionals called the general partners or sponsors survey their target markets looking for a favorable deal.
Sponsors typically underwrite and analyze hundreds or even thousands of deals a year in order to find the gems that are suitable for investment.
Once a deal is found, they submit an offer and deposit and put it under contract with the seller.
They then work with a securities attorney to draft legal documents that register the real estate syndication officially with the government.
At the same time, the sponsors are speaking with lenders and acquiring the mortgage financing for the property.
The lender will only fund a certain amount of the purchase price, typically between 65-80%, through debt. Whatever is left over must be provided by the sponsors and their investors as equity.
Once the opportunity has been filed with the SEC, it is now an official syndication investment offering.
The sponsors then raise money from their investor base. Any investors that contribute to the offering become what are known as limited partners in the syndicate.
How are Investors Compensated?
So once these investors become limited partners in the deal, how are they compensated? Enter the preferred return.
A preferred return is simply a form of preferential treatment in who receives cash flows during the holding period of the asset or at the time of a sale.
If you have a preferred return, you’re served first — you get the first share of the proceeds, which protects your downside risk.
In practice, this means that even if the general partners couldn’t pay themselves, you will still receive your payment because you are legally in a higher priority position.
Let’s give you an example of a typical preferred return structure. Let’s say you invested $100,000 into a real estate syndication with a 7% preferred return. Each year, you will end up making $7000 on your investment.
Even in the event that the cash flow is not enough to pay back the general partners, you are paid first due to the preferred return and will still receive your investment.
The preferred return you receive is based on your initial equity on an annualized basis.
Cash distribution payments to investors may be made either monthly or quarterly.
Any amounts in excess of the preferred return are then paid out according to the promote structure.
The promote structure stipulates how cash flow during the hold period or profits at the time of sale are divided between the limited and general partners. A typical split would be 70% of all remaining cash flows going to the investors and 30% going to the general partners.
For this example, your equity or capital account remains at $100,000 and is not reduced by these annual payouts.
Your capital account will only be reduced based on capital events such as a sale of the asset. All of this language as it specifically relates to a deal you are reviewing will be located in the offering’s private placement memorandum.
For a complete overview of private placement memorandums, please read our Private Placement Memorandum (PPM) Operating Agreement, and Rule 506 For Real Estate Syndication Explained article for more information.
As you can see, this structure provides significant protection to the investors, while also providing tremendous upside when the preferred return is exceeded. This also incentivizes the general partners even further as their return is only realized in the event that the investors have received their full preferred return.
Make sure not to confuse preferred returns with preferred equity. Preferred equity is a separate class of equity investors that occupies its own position in the capital stack, separate from the syndicate. Please read our What is Preferred Equity for Real Estate Investing? article for more information on this topic.
Structure of the Preferred Return
Not all preferred returns are created equal. We need to dig down into the mechanics of the preferred return for the offering in order to understand some subtle details that might go unnoticed by a beginner.
Cumulative Preferred Returns:
It’s very important to make sure the offering is providing cumulative preferred returns. This simply means that in the event that your preferred return is not met one year, whatever amount of your preferred return was not paid out accrues on to the next year.
For example, if you were entitled to a 7% preferred return, but only received 6%, you will then be entitled to an 8% preferred return the following year. You still have a 1% balance from the previous year that gets added to the next year. This provides additional protection to the investors beyond a simple preferred return.
True Preferred Return vs. Pari Passu Preferred Return:
You should also keep in mind that the typical preferred return in real estate is a “pari passu” or “side-by-side” preferred return.
What this means is that the investors are preferred to receive their return on a first-served basis, but once that amount has been paid, the general partners also receive their own equal return to make themselves whole before moving on to the promote structure.
In the event that cash flows are insufficient, the sponsor will usually be the ones left out in the cold and lose their preferred return because they are second in priority behind the investors, but if there is enough cash flow, everyone wins.
A “true” preferred return is extremely rare or non-existent in the industry.
Like most sponsors, we use a pari passu preferred return in our offerings, but we wait until a capital event to pay ourselves back any of those amounts.
What this means is, during each year of the hold period, we pay our investors their preferred return, but don’t pay ourselves our preferred return that year. We simply let our balance accrue each year until we sell or refinance the asset.
Doing so allows us to keep our investors first and wait until there is a far larger pool of capital to compensate ourselves, which keeps pressure off the asset during the hold period and increases our investors’ annual returns.
What if There’s No Preferred Return in an Investment Offering?
If there’s no preferred return in an investment offering, you should be asking yourself why. In our experience, this is usually a bad sign and could mean that the property’s cash flow is insufficient. Irresponsible sponsors will get bad deals under contract that have insufficient cash flow to provide investors with a preferred return.
If there is no preferred return, your projected IRR and annual return should be higher to compensate for the fact that this is a much riskier investment to you without the downside protection of a preferred return.
Make sure the sponsor in a real estate syndication is budgeting properly for capital expenditures, repairs, and operating reserves. They could promise and show a rosy picture with a healthy preferred return, but if their budget is unrealistic and lack sufficient reserves, good luck actually hitting the preferred return they stated! There will always be unforeseen circumstances in real estate and you need to be ready to weather any storms. Prudent planning ahead of time is a must. This is why it is so key to make sure the sponsors you invest with are conservative in their budgeting and projections.
If the asset’s cash flow is sufficient to provide a preferred return, but there still isn’t one, then that usually means that the sponsor is relying on those cash flows to keep the lights on in their business.
That’s also a bad sign.
The sponsor likely does not want to provide a preferred return because they do not want to risk their own cash flow being insufficient during the hold period.
This shows the sponsor got in above their head and doesn’t have the sufficient financial backing to manage the asset properly.
The asset management and acquisition fees should be sufficient for the sponsor to keep their operation running — if they’re removing or reducing investor returns to force everything to work, that’s a problem.
The only person that really benefits in a situation with no preferred return is the sponsor themself, so it’s worth asking why they would not provide a preferred return and what their motivation is in doing so.
As a general rule, we recommend you avoid deals that do not provide preferred returns unless there is additional compensation on the overall return.
If there isn’t, it’s probably a sign of a reckless sponsor trying to force a bad deal to work. It’s critical that the structure of the syndicate protects the investors and the financials for the deal have to stand on their own legs.
We personally would not invest in a deal if it did not provide a preferred return and all of our multifamily opportunities provide a preferred return to our investors.