What is a Preferred Return?

A common characteristic of a cascade of real estate stocks, the preferred yield or “prefs” can be especially difficult for investors who are not familiar with its permutations.

All “prefs’ are computed in different ways. A shared characteristic of a real estate property equity waterfall, the “preferred return” or "pref" may be especially delicate for investors who are not aware of its permutations. All “prefs” are computed in different ways.

What is a preferred return?

As the name implies, the preferred yield is a profit distribution preference whereby profits from operations, sales, or refinancing are distributed to one class of shares before another until some rate of return on the original investment is achieved. The “pref” is indicated as a percentage, as a cumulative return of 8% on the initial investment; however, it can also be indicated as several stock multiples. This preference provides some comfort to investors as it subordinates participation to the benefits of the sponsor or "promotes"

Preferred Return v. Preferred Equity

The preferred return is separate from the concept of "preferred own funds", which is a position in the capital pool that has a repayment priority. The difference is the return on investment and the return on investment. Preferred return is a preference in return on capital, whereas a preferred position in shares is a position that receives a preference in return on capital. In most real preferred share investments, investors get their original investment and earn a fixed percentage return on their investment before the subordinate investor even earns a dollar in cash flow. If the investor does not receive a return on investment before the developer or another portion of capital, then the investor is in a "common" position and not in a preferred capital position. An investor in ordinary shares may still be given a “pref” and the type of proof can be further differentiated based on the treatment of sponsorship capital, known as co-investment. If the investor receives a preferred return before a promoter, then the “pref” is a "true" preferred return.

Preferred performance is a sensitive measure because it may be mistaken for preferred shares.

Investors first receive their capital contributions plus an annualized return of 10 percent before the promoter receives any cash. Secondly, the promoter receives his capital injection. Finally, investors receive 20% of all surplus profits, whereas the developer receives 80% of all surplus profits. Investors benefit from a true preferred rate of return and in return receive only 20% of their profits compared to their true 10% preferred rate of return. Overall, performance is likely to be weaker than if they participated upward in a joint venture equity position, however, they have lower total investment risk.