What are Preferred Returns

As an investor in syndications, you're likely to encounter the term "Preferred Returns." While not all deals offer preferred returns, understanding what they are can be beneficial, even if they aren't a prerequisite for a good deal.

What are Preferred Returns?

A preferred return is an optional provision in a multifamily syndication investment offering that prioritizes returns for investors until they receive a minimum return on their investment. In essence, investors receive a set minimum rate of return before the syndicator (or sponsor) can share in the profits.

How are Preferred Returns Calculated?

For example, consider a syndication offering a 75:25 split between investors and sponsors with a 6% preferred return.

This means that until investors achieve a 6% annual return on their investment, all income is distributed to the investors. Once the 6% return is allocated to the investors, the remaining profits are split between investors and sponsors, with investors receiving 75% and the sponsor receiving 25%. The accompanying flowchart shows the process of calculating profits for investors and sponsors, while taking into account the preferred returns.

Preferred Returns Boost Overall Investor Returns

As illustrated in the flowchart, the remaining profits are split between investors and sponsors only after preferred returns have been deducted from the proceeds. This not only ensures investors receive a minimum annual return but also boosts their overall returns.

Other Important Points

Investors should pay close attention to and clarify with the sponsor whether preferred returns are cumulative. If the preferred return threshold isn't met in a given year, will the remaining amount owed to investors be carried over to the next year?

Since sponsors are essentially foregoing profits upfront to demonstrate their confidence in the deal, preferred returns are often paired with "sponsor catch-up." This provision allows the sponsor to receive a larger share of profits after the promised total returns to investors have been achieved.