Preferred Return: 7 things for apartment investors to know

If you are investing in apartment syndications, it’s critical that you fully understand the term preferred return. In this article, we’ll be defining this term and giving you 7 things to know about this very important structural preference for investors in apartment syndications.

First, let’s define an apartment syndication as the collective pooling of capital from “smaller” investors to acquire and operate a large multifamily property for the purpose of paying returns to general and limited partners. Investors are referred to as limited partners, which are passive, liability-shielded participants. General partners are the individuals with the active role in the syndication.

The preferred return is the annual payout target to each investor, expressed as a percentage of the investment. For example, if an offering is structured with a 6% preferred return, then the target yearly cash distribution would be 6% of the amount the investor originally invested in the offering. For a $100k investment, this would target a $6k cash distribution to that investor.

Here’s 7 things investors should know about preferred returns:

1. Prioritizes the investor ahead of the general partners

This is the most crucial thing to know, and it’s why we advise investors to only invest in deals that have a preferred return. That’s because it gives “preference” to the investor (limited partner) over the individual(s) operating the offering (general partners). In essence, it creates a waterfall on how operational cash flow is treated. When there is ample, positive cash flow from the property, the syndication must pay investors the preferred return first. Only once the syndication pays to this target can it then start to split operational profit to the general partners along the equity split.

For example, let’s take a syndication that has a 6% preferred return and a 70/30 equity split. The general partners cannot be paid from operational cash flow until the first pay investors to the 6% annual threshold. Then, if there is remaining cash flow it follows the waterfall and is split 70% to investors and 30% to the general partners. This truly ensures investors are put first, but it also incentivizes the general partners to perform well for their investors in order for them to be compensated.

2. Not a guaranteed annual yield

Notice how our definition is with respect to coming from “ample” cash flow? A preferred return is not part of operational expenses. Rather it is paid when there is significant enough cash flow after all expenses. That’s important because investors can get confused and think preferred returns are the same as the annual yield on a CD or government bonds. Those fixed return investments must pay their annual yields—no questions asked.

But, that’s not the same as a preferred return in apartment syndications. It’s best to think of it as a contractually-obligated “we owe you X before we pay ourselves.” When the cash flow is ample enough, the preferred return is paid. But, in the event cash flow is not adequate (or some other hurdles exist), the preferred is not paid in full.

A side note to this conversation is that while bonds and CDs provide guaranteed, fixed income, they do not have the tax benefits associated with distributions from apartment syndications.

3. Accrues when not paid in full

Having worked with hundreds of investors, we have seen this aspect overlooked by more than a few investors. Considering we often are personally invested alongside our investors, we can understand the frustration when a syndication does not pay its full preferred return. Yet, the key thing is that any shortfall on a yearly basis is accrued and added to the subsequent year’s preferred return.

For example, let’s say a syndication paid a 5% return but had a 7% preferred return. That syndication still owes the investor 2% and its accrued. The following year, the accrued preferred return is now 9%. And so on and so forth.

This continues to put the investors first because the general partners are still not being paid from profits until the preferred return is met—that includes any accrued return.

4. There can be hurdles beyond cash flow

We defined the preferred return above with respect to payouts from ample operational cash flow. There’s some added nuance to this definition that we have encountered and believe investors should know. And, it has to do with the largest investor in every property: the lender.

The reality is the largest and most-prioritized investor in any property is the lender. They won’t contribute acquisition funds (debt) unless they are guaranteed a certain % return (interest) and given first preference in payout (mortgage payment). In order for lenders to be successful in not losing money, they can make rules the borrower must follow that further stabilize their ability to get paid.

Translation: the lender can contractually prevent investor distributions in some situations even if there is positive cash flow from the property. For example, the lender may require a threshold of positive cash flow be met before paying distributions. Or, they may require a certain debt-service-coverage-ratio. Lenders can also require a certain amount of the capital expenditure budget be executed for property improvements before distributions can be paid. Or, they can require certain interest or operational cash reserves be funded before distributions.

Some lenders are less restrictive than others. In reality, each situation is unique but the point is sometimes the payout of a preferred return is affected by more than just having ample cash flow. Yet, the protection for investors, again, is that the preferred return accrues if one of these hurdles affect payout of distributions.

5. Not the same as “Cash-on-Cash Return”

As with most things, terms that are meant to clarify can often lead to more confusion. One of the biggest confusions is equating a preferred return with cash-on-cash return. The preferred return is the contractual obligation to pay investors before general partners are paid. Whereas the cash-on-cash return is the actual payout of distributions. The cash-on-cash return can be lower or higher than the preferred return.

Most investors first encounter cash-on-cash return as a projection within an investment offering. When general partners create an offering to investors, they will present projected returns such as total return, IRR, average annual return, and cash-on-cash return. Really, what the term is referring to is what the general partners are projecting to be the actual distributions paid to investors as a percentage of their initial investment. Often, the cash-on-cash is projected on a year-by-year basis in the investment offering’s pro forma return model.

It’s not uncommon for the cash-on-cash return to be lower than the preferred return during the initial years of a syndication. For example, a syndication may have a 7% preferred return but its pro forma return model may project a 4% cash-on-cash (actual distributions) in year 1 and a 10% cash-on-cash in year 2. If that came to fruition in year 1, it would mean that 3% of the preferred return carried over into year 2 but that the syndication was able to meet and exceed the accrued preferred return.

That can sound a little confusing but think of cash-on-cash as actual distributions—and if cash-on-cash is lower than the preferred return in any one year, the deficit is accrued onto the following year’s preferred return target for investors.

6. Will vary from deal to deal

There is a range of preferred return percentages that investors will encounter as they review apartment syndication offerings. A very common range is 5 to 8%, but it will vary. 7% and 8% were very common preferred returns in recent years. However, as rising interest rates and reduced leverage from lenders impacts underwriting of cash flow, it will be increasingly common for investors to see preferred returns in the 5 – 6% range.

7. Doesn’t Reflect Total Return

While we think investors should only invest in apartment syndications that have a preferred return, it’s not reflective of total return for investors. Yes, the preferred return is focussed around prioritizing the passive income aspects of these investments. However, apartment syndications’ greater return is truly found in equity growth.

When we look at the life-cycle of most apartment syndications we find 3 stages: asset improvement (physical/operational), growth on NOI, and sale of the asset at higher value due to the NOI growth. Apartment properties are essentially valued like businesses. Valuations go higher as profit goes higher. As the general partners work to increase NOI, the investors will experience equity growth which will be realized as profit from the eventual sale of the asset. It’s this total return over the lifecycle of a syndication that we believe investors should consider—in addition to the very important aspects of a preferred return.

In closing, we highly encourage you to consider apartment syndication offerings that clearly put investors first by way of the preferred return structure. There’s many aspects of this structure to consider when investing but we also encourage investors to consider them among the greater context of these offerings.

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