In a real estate investment context, a preferred return refers to a priority distribution of profits to investors before any other distributions are made. It's a way to ensure that investors receive a certain percentage of their investment back before other parties, such as the sponsor or managers, receive their share of profits.
Here's how it typically works in a real estate investment capital stack with a preferred return:
Investment Capital Stack: This refers to the structure of funding sources for a real estate project. It usually includes various types of capital, such as senior debt, mezzanine debt, equity, etc., each with its own priority and risk-return profile.
Preferred Return: Let's say an investor commits $1 million to a real estate project with a preferred return of 8% per year. This means that before any profits are distributed to other participants, such as the sponsor or developers, the investor will receive an annual payment equal to 8% of their initial investment, i.e., $80,000 in this case. This is typically determine when the property is sold. Not to be confused for cash and cash return.
Distribution Priority: The preferred return is typically paid out before any profit-sharing arrangements, such as promote or splits, come into play. This ensures that investors receive the projected return on their investment before others benefit.
Promote or Splits: Once the preferred return is met, any additional profits are then typically split according to the agreed-upon terms. For example, the sponsor may receive a promote, which is a share of profits above and beyond the preferred return. This promote is an incentive for the sponsor to perform well and generate higher returns for investors.
Overall, the preferred return serves as a safeguard for investors, ensuring they receive the projected return on their investment before other parties participate in profit-sharing. It's a key component of structuring real estate investments to align the interests of investors and sponsors.
If this article piqued your interest in investing in real estate, then congratulations:
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