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What Is A Preferred Return?

Jul. 22, 2013 2:01 PM ET
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Seeking Alpha Analyst Since 2013

Phil Champagne, Managing Partner, Wren Investment Group, LLC Phil's 12 years of experience in commercial and single family investment along with his passion for macro-economics, positions him well to guide the investor through each step of the acquisition, re-position & asset exit phases of the investors participation window. Phil is also instrumental in the formulation of acquisition strategies.

In some investments, an investor may be offered a preferred return in order to make the offer more appealing, interesting and advantageous over other investment alternatives. We are asked often what exactly is a preferred return as we regularly structure our multifamily offerings such that they provide preferred returns to our investors. So what exactly is a preferred return:

A company who sources a property with potential, negotiates an exceptional deal, funds the earnest money deposit, funds & completes due diligence and financing may bring investors into the deal where these investors provide the equity required to complete the acquisition in exchange for a participatory position in the financial performance of the asset. Once acquired, this company will manage the asset to improve its management, increase operational efficiency, raise rental income, strategically invest in capital projects to improve the appeal of the property, etc. Both this company and its investors share in cash flow & equity participation of the property, however, when a preferred return is involved, investors are prioritized over management company where cash distributions are concerned.

For example, let's take a hypothetical case of a $10,000,000 property which was purchased with a $2,000,000 equity and a $8,000,000 mortgage. After all expenses, let's assume this property is cash flowing $300,000 per year. This yields a cash on cash return of 15% ($300,000 divided by $2,000,000). Say the company structured the offering with an 8% preferred return to the investors and a 75% equity position (ownership). An 8% return for a $2,000,000 investment would translate to $160,000, remember this figure. The figure below illustrate the distribution based on different yearly cash flow scenarios.

Say on the first year the property has a net cash flow of $300,000 as expected, then the distribution goes like this:

  • 75% of $300,000 to the investor = $225,000
  • 25% of $300,000 to the company = $75,000

The investors receive an effective return of 11.25%.

Now instead, imagine some important event has created a difficulty for the property during that first year and rather the net cash flow was actually just $200,000, in such case:

  • 75% of $200,000 is $150,000
  • 25% of $200,000 is $50,000

Since $150,000 would yield a return of 7.5% which is under the preferred return, the distribution is changed to:

  • $160,000 to the investor (or 80% of the net cash flow)
  • $200,000 - $160,000 = $40,000 to the company (or 20% of the net cash flow)

In other words, the investor has priority in the distribution to at least maintain the preferred return as a minimum. In this example of course, if things are much worse and the cash flow is limited to only $100,000, then all goes to the investor and nothing to the company.

On the other hand, if the project performs better than projected, the 75% equity position of the investors means the investors returns will also beat their projections in a manner commensurate with their ownership position.

At the time of sale, the initial equity investment of $2,000,000 is returned to the investors and then 75% of the balance goes to the investors while the remaining 25% goes to the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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