Commercial Real Estate

Real Estate Syndication: What Is a Preferred Return?

Expertise: Commercial Real Estate
18 Articles Written
apartment-units

If you’ve been looking to invest passively in a real estate syndication, you’ve probably noticed that most syndications offer a feature called preferred return. It seems that as awareness of syndications has increased so have misconceptions about preferred return.

Want more articles like this?

Create an account today to get BiggerPocket's best blog articles delivered to your inbox

Sign up for free

Let’s clear up what preferred return is and, more importantly, what it is not.

What Is a Preferred Return?

Some people (investors and sponsors alike) think that a preferred return is a guaranteed payment—that the money must be paid on a schedule, like a loan payment. Not so.

Preferred return simply means that the investor is in a preferred position. In other words, they have priority when distributions are made. Until the preferred return hurdle is met, investors get 100 percent of whatever is distributed. If nothing is distributed, the investor gets nothing.

Yet, some syndication sponsors market to investors as if the preferred return is the amount they should expect to be receiving right away. While that might sound desirable, there are a lot of negative implications to this practice if the real estate doesn’t produce enough cash flow to meet this promise.

This shortage is not uncommon at all when buying an underperforming property where the business plan is to improve the property and increase the income as the improvements are made. In the first two to three years, the cash flow thrown off by the property is typically somewhat weak—such as 4, 5, or perhaps 6 percent.

If the preferred return is 8 percent, there is not enough cash flow to make an 8 percent distribution in the early years.

How Preferred Return Works

Let’s break this down with an example of how preferred return distributions should work. Let’s say that the syndication’s operating agreement sets the preferred return hurdle at 8 percent, and it’s cumulative but non-compounding.

cash-flow

In this instance, assume that the property produces enough cash flow to distribute 4 percent in the first year. The investors get all of the distribution because they are in a preferred position—they receive all cash flow until they have been distributed 8 percent annually.

There’s only enough cash flow to distribute 4 percent, however, so 4 percent gets distributed and the other 4 percent carries over to the next year and beyond.

If in year two the property throws off enough cash flow to distribute 8 percent, the investors get all of the distribution. If in year three the property throws off enough cash to pay 12 percent, the investors still get all of the distribution, because they are owed 8 percent to meet the preferred return accrued this year, plus the 4 percent shortfall from year one.

If in year four the property throws off 12 percent again, the investors get 8 percent to meet the preferred return accrued this year, and the remaining 4 percent is typically split between the investors and the sponsor by a ratio specified in the operating agreement.

It’s common for the investor to receive between 50 percent and 80 percent of this surplus. In some structures. the surplus isn’t split. Instead, it’s distributed to the investors as a return of capital.

Related: A Real Estate Investor’s Guide to the Equity Waterfall

Distributing More than the Property Earns

Using the example above, how could a sponsor distribute 8 percent to their investors in year one?

An odd and disturbing trend I’m seeing a lot lately is sponsors raising additional capital and making cash flow distributions equivalent to the preferred return hurdle regardless of the performance of the real estate. The reason I say that it’s odd is it is just like saying, “Give me $100,000. I’ll invest $85,000 of it in real estate, and I’ll give you the remaining $15,000 back in quarterly installments over the first two to three years.”

As an investor, I’d say, “Uh, no thanks. I could invest $85,000 with you instead and keep my $15,000!”

Why would sponsors do this?

Some might do this to mask the true performance of the investment, obscuring the actual results from unsuspecting investors that don’t know any better. These investors confuse distributions with performance and think that as long as they are getting their distributions, everything is going just fine. Meanwhile, the property could be in deep trouble and the entity could eventually run out of cash.

Pensive afro american handsome professional writer of popular articles in blog dressed in trendy outfit and glasses thinking over new story proofreading his script from notebook sitting in cafe

More commonly I suspect that the reasons are less nefarious—perhaps just a marketing strategy, a way of attracting capital. They can tell their investors that they will “make” 8 percent on their money right away. Some investors don’t take the time to do the math and accept it as a “great return.”

Perhaps some sponsors are doing this because they don’t know how to accrue a preferred return properly, thinking that if they just distribute whatever the preferred return is, they don’t have to track it.

Creating waterfall tracking models is one of the most challenging facets of commercial real estate. Many sponsors may be good at real estate but less so at programming spreadsheets. And there aren’t a lot of off-the-shelf products to solve this challenge.

How cash flow is split between sponsors and investors varies widely from one syndication to another, meaning that there are too many variables to make a commercial solution viable. Some have tried, but I’ve tested a few and haven’t found any that work correctly for many structures.

Related: 7 Ways to Organize & Structure a Real Estate Syndication

Ethical or Not?

If sponsors are distributing to the preferred return hurdle regardless of the underlying cash flow because they think it’s good marketing, or if they just don’t know how to properly track preferred returns, it’s not illegal nor unethical—as long as it’s all disclosed and the investors understand exactly what is going on. If you are going to hold onto my money just to give it back to me in installments, just tell me. Then I can decide for myself if that’s to my advantage.

But are sponsors disclosing it?

If they are, there should be a line item on the sources and uses of funds table showing exactly how much money the sponsor is raising to supplement early-year investor distributions. But I see a lot of offerings from sponsors that don’t include a sources and uses of funds table at all.

Investors in these offerings truly have no idea where the money is going. Not good.

What if the sponsor isn’t showing any money being raised for this purpose? In that case, where is the money coming from?

Maybe the sponsor is robbing Peter to pay Paul, siphoning money that was intended to be held in reserve for a rainy day or was intended to be used to renovate the property. This would compromise the business plan or even the company’s solvency.

The Practice Comes at a Cost

I’ve heard some investors say that they like to receive distributions equal to the preferred return hurdle from the beginning of the investment. That makes sense, but at what cost?

calculating-cash-flow

At best, this practice is tying up money that isn’t invested in real estate. Rather, it’s just held in cash by the sponsor to give back to the investor. At worst, it could be compromising the financial integrity of the company.

But even if it all works out, it comes at a price. The overall return on the investment is a function of the amount of money raised and the amount of money returned. This means that raising additional capital for the purposes of inflating early returns actually lowers the rate of return for the investment overall.

More dollars in for the same profit out.

Is This Happening to You?

Do you know if the sponsor behind the syndication you invested in is distributing more than the underlying assets are producing?

If they are, hopefully you can say “yes” because it was disclosed to you up front, and you knew this was happening. You didn’t mind having them hold onto your funds and returning them to you in installments, even if this lowered your overall return.

No harm, no foul.

But what if you don’t know? Or if you think the answer is no, but it’s really yes? How do you find out?

Hopefully you are receiving an income and cash flow statement as part of your periodic reporting.  I know they can be boring and sometimes confusing, but it’s a good practice to review them. Distributions do not represent performance—only the income and cash flow statements can represent performance.

Don’t fall into the trap of complacency by thinking that all is well just because you are receiving checks. If the cash flow statements do not show that the property is throwing off enough cash to support the distributions you are receiving, the investment might be in trouble despite the fact that you are receiving distributions.

Ponzi schemes come to mind as a similar example.

These are scams where the promoter is distributing more money than the underlying investments (if there are any) are making, using money from new investors to pay old investors. Ponzi-style scams are fortunately quite rare in the real estate syndication space, but they are out there.

Comparing property-level cash flow to distributions is one way to spot this type of activity. If the cash flow statements show the property threw off $100,000 in cash flow, but the sponsor distributed $500,000 (and there was no cash-out refinance), it's probably a good idea to ask a few questions.

Brian Burke Hands Off Investor book ad

Questions? Comments?

Let’s discuss below!

Brian Burke is president/CEO of Praxis Capital Inc, a vertically integrated real estate private equity investment firm, and author of
Read more
    Jerome Myers Rental Property Investor from Greensboro, NC
    Replied 9 months ago
    This is a great articlr Brian. I am seeing the practice of overfunding to pay out on the first month and it makes me cringe. You are thoughtful in the approach jere but that just screams ponzi scheme to me... the other thing i struggle with is the dilution of equity... i want to control the equoty created from executing the business plan for as little money invested as possible... this has hurt me in the pass because i had to make interest free loans to the property... but i still don't see raising to pay equity as a strategy... i feel like they are treating investor payouts as debt service or even a salary... those are not the same
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Thanks for your input, Jerome. I agree--I've always been a believer in raising additional capital for the purposes of retaining cash reserves for a rainy day (or a Pandemic?!), but not to simply turn around and distribute it back to investors. Makes little sense.
    Jerome Myers Rental Property Investor from Greensboro, NC
    Replied 9 months ago
    Sorry for the typos...
    Lance Pederson Specialist from Portland, OR
    Replied 9 months ago
    Great article Brian! I hope all is well with you! I'm glad to finally see someone write about this issue as I see it all of the time. Sponsors are so worried about paying out the preferred return in real time that they do all sorts of crazy things. As you've pointed out it's a bit of a slippery slope. I've found that most sponsors just don't understand the accounting implications of distributing more cash than the partnership has generated in income. I've even seen it where the sponsor continues to calculate the pref on the original capital contributions even though they've technically been paying down the capital account the entire time. The other bad part about this is that it creates a mess come tax time and is often the reason why their CPAs end up charging them an arm and a leg to prepare the partnership tax return. They spend hours trying to untangle everything and then the investor ends up being totally confused when they get their K-1.
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    So true, Lance. All great points. One of the hardest things in commercial real estate is carving up the cash flow properly. It's surprising how many syndication sponsors don't know how. I'm sure that's why your business has become so popular!
    Brett P Swarts Specialist from Sacramento, CA
    Replied 9 months ago
    Excellent article and well said Brian. I love fresh content like this which clearly lays out what many may be missing.
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Thanks Brett!
    Sulaiman Shah Real Estate Investor from Staten Island, New York
    Replied 9 months ago
    Thanks for clearing this out. This helps out so much because I didn’t want to be dealing with preferred returns that are like a loan.
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Right--debt payments and preferred returns are so different, mixing up the concept defeats the purpose.
    Andrew Hogan Specialist from Indianapolis, IN
    Replied 9 months ago
    Great stuff Brian and totally agree that good operators raise beyond the minimum for cash reserves but never to pay others' returns.
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Yeah, and it's times like this (in the midst of a Pandemic as I write this) that strong cash reserves are so important.
    Ashley Wilson Rental Property Investor from Radnor, PA
    Replied 9 months ago
    Great article Brian! Taking this one step further, in value-add properties, as an investor if you are truly educated on the investment and how it works, you would want your money working for you. I know I don't have to spell this out for you but for anyone else who is reading this, you can maximize your investment by reinvesting early returns to help reposition the property faster and stronger, ultimately resulting in a higher evaluation. I mean that is one of the secret powers of MF in the first place, right? I know passive investors want to truly be passive, but setting expectations up from the beginning through education, and being transparent, as you mention in your article only helps everyone in the long run. Thank you as always Brian for being so honest!
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Thanks Ashley! You are so right--so much of this business is managing expectations. Expecting the preferred return to be fully distributed from day one is an improper expectation. :)
    George Lui Investor from Palo Alto, CA
    Replied 9 months ago
    Great article! As someone new to the syndication front, this piece of information is profound!
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Glad you enjoyed it, George!
    Rudy Curtler Rental Property Investor from Minneapolis, MN
    Replied 9 months ago
    Great article Brian. And I appreciated the info you shared on show #378 with Brandon and David. As a new syndicator, I am looking forward to getting your book to understand both sides of the equation. Thank you, Rudy
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    I appreciate the feedback, Rudy! Thanks! I hope you enjoy the book. :)
    Ron Ripley Investor from Walnut Creek, CA
    Replied 9 months ago
    Hi Brian - great article on an important topic. I literally just finished your new book yesterday and recognized the text from this article. You should have mentioned this as an expert from your book, thus promoting said book (which is excellent, by the way - thanks!) :-) Have a great weekend.
    Ron Ripley Investor from Walnut Creek, CA
    Replied 9 months ago
    excerpt - not expert. lol
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Thanks for the comments on the book! I'm glad you enjoyed it!
    Embert Madison jr Attorney from Sacramento, CA
    Replied 9 months ago
    Brian, thanks for sharing this awesome information! I'm going to have to pick up two copies of your book. One for me and one for @alwilliamson!
    Brian Burke Investor from Santa Rosa, CA
    Replied 9 months ago
    Awesome, let me know what you think of it!
    Bernadeau C. Rental Property Investor from Orlando, FL
    Replied 3 months ago
    Does anyone have an excel spreadsheet template for the preferred return model that I could use? I am looking to start syndicating smaller multifamily deals. Any help would be appreciated