Real Estate Syndication: What Is a Preferred Return?
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.
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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.
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.
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.
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.
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?
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.
Let’s discuss below!