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What Is a "Preferred Return" in Real Estate Investing?

Writer's picture: Rose PelipelRose Pelipel

Updated: 4 days ago

When diving into the world of real estate investing, you’ll often hear the term "preferred return" come up, especially when discussing syndications, joint ventures, or private equity deals. It’s a critical concept to understand if you want to evaluate investment opportunities and determine how returns are structured. But what exactly is a preferred return, and why is it so important?


The Basics: What Is a Preferred Return?

A preferred return, often referred to as a “pref”, is a predetermined return on an investment that is paid to certain investors before others receive their share of the profits. It’s essentially a way of prioritizing specific investors—often those who contributed the capital—by guaranteeing they earn a minimum return before any profit-sharing or additional distributions occur.


How Does a Preferred Return Work?


Let’s break it down:

  1. Priority Distribution: Investors entitled to a preferred return receive a specified percentage of their initial investment (often referred to as the “capital contribution”) before other stakeholders, such as general partners or sponsors, earn a share of the profits.

  2. Rate of Return: The preferred return is usually expressed as an annualized percentage. For example, if a deal offers an 8% preferred return, an investor who contributed $100,000 would expect to receive $8,000 per year in returns before the sponsors receive any profit participation.

  3. Profit After the Preferred Return: Once the preferred return is paid, any additional profits are typically split based on a pre-agreed ratio between the investors and the sponsor (e.g., 65/35, 70/30 or 80/20).



Why Does a Preferred Return Matter?


The preferred return structure is designed to incentivize investors to fund projects and align their interests with the sponsor or operator. Here’s why it’s a big deal:

  • Risk Mitigation for Investors: The preferred return offers a level of security by prioritizing the investor’s earnings before the sponsor takes a cut of the profits.

  • Incentive for Performance: For sponsors, this structure motivates strong operational performance because they only share in profits after the preferred return is met.



Real-Life Example


Imagine you invest $100,000 in a real estate syndication deal with an 8% preferred return. Here’s how the returns might look:

  1. Preferred Return Paid First: You receive $8,000 annually from the property’s cash flow or sale proceeds before any profit-sharing.

  2. Remaining Profit Split: After the preferred return is distributed, the remaining profits are divided—say, 65% to the investors (you) and 35% to the sponsor.


If the deal generates $120,000 in profits, here’s how it would break down:

  • First, you’d receive your $8,000 preferred return.

  • The remaining $112,000 would then be split, with $72,800 (65%) going to investors and $39,200 (35%) going to the sponsor.



Key Considerations


While a preferred return is an attractive feature, it’s important to understand the fine print. For instance:

  • Is the preferred return cumulative? This means unpaid preferred returns roll over to the next year.

  • How does the deal structure handle shortfalls in income or profitability?



What This Means for You

If you’re evaluating a real estate investment opportunity, the presence of a preferred return can provide clarity on how returns will be distributed and where you stand as an investor. Understanding these details allows you to make more informed decisions and ensure that your investment aligns with your financial goals.




At BPG Holdings, we work with investors to structure opportunities that balance risk and reward while prioritizing transparency. If you’re interested in learning more about real estate investment structures like preferred returns, we’re here to help.  Happy Investing! 


 

Cassidy Burns is the owner of BPG Holdings, a vertically integrated real estate investment firm specializing in real estate investment strategies and portfolio growth for the long term.









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