SS103: What is a Preferred Return?

A normal part of private equity is the “preferred return.” In this episode, Charles explains what a preferred return is and how it influences private equity real estate investing.

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Talking Points:

  • A preferred return; often called “pref” or the hurdle rate, is the minimum return that limited partners (passive investors) in a deal must receive before an investment manager or operator is able to earn a performance fee.
  • Typically, preferred returns are between 6%-9%; depending on the deal’s risk. The preferred return is not a guaranteed payment though.
  • Performance fees help best align the interests of the passive investor and the investment manager. If the manager does perform; they will be compensated. On the other hand, an investment manager will not partake in deals where they do not think they will substantially outperform the preferred return. This is a benefit for all parties; you only want to invest in deals with a sizeable upside.
  • A couple of preferred return examples:
    • If you invest in a deal with an 8% preferred return and in year 1; the investment manager returns only 6% in returns to you; in other words, there is a deficit of 2%; this 2% is accrued and next year; the investment manager will add that 2% onto the 8% preferred return for year 2 and this will continue until the preferred return is paid out completely (so if they were to fully catch up in year 2, 10% would need to be paid out). The operator must pay the preferred return before they are able to receive a performance fee. Some deals; like construction projects; will most likely not have any distributions until year 2 or 3 so that preferred return continues to accrue.
    • A second example would be a deal that has an 8% preferred return and it is an 80/20 split. 80% to the investor and 20% to the investment manager; and the deal begins to generate 13% returns. The limited partner investor would receive their 8% preferred return AND THEN 80% of the excess distribution (above the preferred return so 8% + 4% or 12% in total) while the investment manager would take 20% of the distribution over the 8% or 1% in this example.
  • It is also important to note that the investment manager will most likely be paid other fees prior to receiving a performance fee. For example; they were most likely paid an acquisition fee when the property closed and are most likely receiving a monthly asset management fee, but these fees are really just covering expenses for the investment manager; their staff, office, and travel; really just “keeping the lights on.” The operator makes the majority of their money on the performance fee; also known as the carry; their carried interest. It motivates the operator to deliver large returns to limited partners. Exactly what you as the passive investor want the operator of the investment to be focused on, large returns. A true alignment of interest. This is why this fund structure of private equity and carried interest has worked successfully for several hundred years.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing what is a preferred return.

Charles:
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Charles:
A preferred return, often called prep, or the hurdle rate, is the minimum return that limited partners, passive investors in a deal must receive before an investment manager or operator is able to earn a performance fee.

Charles:
Typically, preferred returns are between 6% and 9% depending on the deal’s risk. The preferred return is not a guaranteed payment, though performance fees help the best align the interest of the passive investor and the investment manager. If the manager does perform, they’ll be compensated on the other hand, and an investment manager will not partake in deals where they do not think they’ll be able to substantially outperform the preferred return. This is better for all parties because you only wanna be investing in deals with sizable upsides. Now, a couple preferred return examples would be if you invest into a deal with an 8% preferred return, and in year one, the investment manager returned only 6% returns to you. In other words, there is a deficit of 2%. This 2% is accrued, and next year the investment manager will add that 2% onto the 8% preferred return for year two, and this will continue until the preferred return is paid out completely.

Charles:
So if they were to fully catch up in year two, 10% would need to be paid out in year two. The operator must pay the preferred return before they’re able to receive a performance fee. Some deals like construction projects will most likely not have any distributions until year two or three, so that preferred return continues to accrue. A second example would be a deal that has an 8% preferred return, and it is an 80 20 split, 80% to the investor and 20% to the investment manager, and the deal begins to generate 13% returns. A limited partner investor would receive their 8% preferred return, and then 80% of the excess distribution above the preferred return. So 8% plus 4% or 12% in total, they would receive while the investment manager would take 20% of the distribution over 8% or 1%. In this example, it is also important to note that the investment manager will most likely be paid other fees prior to receiving a performance fee.

Charles:
For example, they were most likely paid an acquisition fee when the property closed and are most likely receiving a monthly asset management fee. But these fees are really just covering expenses for the investment manager, their staff office travel, really just keeping the lights on. The operator makes a majority of their money on the performance fee, also known as Kerry, their carried interest. It motivates the operator to deliver large returns to limited partners, exactly what you as a passive investor, want the operator of the investment to be focused on large returns, a true alignment of interest. This is why this fund structure of private equity and carried interest has worked successfully for several hundred years. So I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics at globalinvestorspodcast.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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