Preferred Return Effect on Total Return on Investment

 This is a pretty in-depth idea that has a lot of moving parts / components. I will try to keep it high level and as understandable as possible. Basically, the idea is to take a look at how the existence of a preferred return can impact investors and operators (LPs / GPs) as opposed to not having a preferred return that is due and simply splitting the cash flows at a defined rate.

Relevant Templates:

A preferred return can impact the return on investment (ROI) for real estate deals in several ways. First and foremost, a preferred return is a type of fixed return that investors receive before the sponsor or the general partner receives any share of the profits. As a result, offering a preferred return can make real estate deals more attractive to investors, since it provides a predictable and steady return on their investment.

The preferred return can also affect the profit sharing structure of a real estate deal. For example, if the preferred return is set at 8%, the sponsor may only be entitled to share in the profits above that 8% threshold. This means that the sponsor's profit potential may be limited by the preferred return, but it also ensures that investors receive a predictable return on their investment.

In addition, a preferred return can impact the risk/reward profile of a real estate deal. By offering a preferred return, sponsors may be able to attract more conservative investors who are looking for a steady income stream, rather than those seeking higher risk and higher reward investments. This may result in a lower overall return on investment, but can also provide more stability and predictability.

Deeper Look

You have to think of it like a risk vs. reward. An LP that goes into a deal with no preferred return is likely to have a much higher share of the profits with a much higher potential return on investment while a deal with a preferred return means there is very likely a limited upside for the LP so the total potential return on investment may be lower but more predictable. 

On the GP side of things, having a preferred return due each period means less cash flow for the GP if the operating cash flow after debt barely covers the return due to the LP. So if the GP is investing a small amount, they may not receive much of a return on their investment until the exit or REFI event.

All of this becomes even more of a complexity to manage if the preferred return due is attached to preferred equity, meaning 100% of the equity must be repaid until cash flows are distributed to the GP. For an LP, the least risky type of deal is going to be one with the preferred return being represented by an IRR hurdle rather than a simple interest non-compounding return. In this scenario, the upside potential is often heavily favored for the GP once they achieve the LPs hurdle rates, but up until that point the GP won't earn much. I have done templates that try to even this out by offering the GP a catch-up provision.

IRR Hurdle and ROI

With the IRR hurdles, the IRR and total return on investment may be much different and the IRR ensures that no matter how long it takes to reach the hurdle, that time value of money is going to be captured by the LP and so the return on investment could be really high if a lot of that cash flow comes at the end of the deal and vice versa if it comes at the beginning of the deal.

Overall, a preferred return can have a significant impact on the return on investment for real estate deals, by providing a predictable income stream to investors, influencing profit sharing structures, and affecting the risk/reward profile of the investment.