Apartment Syndication Preferred Return vs 8% Compounding Interest

7 Replies

It depends. I know, worst answer ever, but...

If the 8% compounding interest is guaranteed, like in a bank CD (not that any come even close to that rate), then I'd take that all day long over an 8% preferred return.  The reason is, a preferred return is simply a claim to cash flow up to reaching the hurdle.  If the apartment building only throws off a 4% return, and then sells at a break-even, all you'll ever see is 4%.  If the deal results in a loss, you'll have a loss.

If the instrument paying compound interest is well secured, such as a deed of trust or mortgage secured by real estate at a low loan-to-value ratio, even in the event of a default you could likely recover your principal and all of the accrued interest.  A syndication investment has less priority on the capital stack so by it's very nature the relationship between your capital and the underlying real estate usually starts out greater than 1:1, meaning the real estate has to increase in value just to get back to even (due to sponsor fees and closing costs).  

Another factor is whether there are other splits over the 8% preferred return.  If you get a percentage of profits that exceed the pref, then that sways favor to this investment because you have a good chance of earning greater than 8%, in some cases far greater.  

Some syndicators are offering a "preferred" class of membership interests, which pay a preferred return but have no further profit split.  Whether those are better than guaranteed compound interest depends on whether the preferred class has priority over the other investor classes.  If so, then the chances of actually seeing the 8% are higher, because you have the first claim on cash flow.  

Another wrinkle is some preferred returns are non-compounding, and others are compounding.  Comparing a preferred return to compounding interest wouldn't be an apples-to-apples comparison without knowing whether the preferred return compounds or not.  

Then there is the matter of distributions.  If 8% is regularly distributed, no compounding takes place.  And if it is distributed, do you have the option to reinvest it so that it does compound?  If not, the compounding question is moot.

So, it depends.  :)

Great response by @brian as usual. In an efficient market the outlined question is unlikely as the compounding asset will have a higher return but inherently also more risk for those assets. Key is not one or the other, but diversification