Let’s face it – distribution waterfalls can be confusing. This article aims to demystify preferred returns, and the order in which stakeholders in real estate projects receive distributions. As you probably know, EQUITYMULTIPLE offers investment opportunities across the capital stack: senior debt, preferred equity (or “pref equity”) and common equity. In this article, we take a look at the difference between preferred equity and the different kinds of preferred return, and how all play out with respect to distribution waterfalls.
So What Is a Preferred Return in Real Estate?
At a basic level, preferred return refers to the ordering in which profits from a real estate project are distributed to investors. Preferred return means contractual entitlement to distributions of profit (from net cash flow) until a threshold rate of return has been met, before profit distributions are made to any other subordinate stakeholders in the project. Note that the structure of equity and the distribution waterfall varies from deal to deal. We’ll get to a couple examples in a bit.
Is Preferred Return the Same as Preferred Equity?
These are different concepts that are often closely related, which can be confusing. Preferred equity refers to a specific position in the capital stack (you may recall the graphic on our homepage illustrating where preferred equity sits relative to senior debt and common equity).
Preferred Equity gets paid out before Common Equity, and is priced at a certain percentage return (called a preferred return). That return can be paid current out of cash flow, accrue and be paid upon a sale, or a combo of both.
Upon repayment of preferred equity, the remaining cash flow goes to common equity partners (through a distribution waterfall). Often, the first two tiers of the distribution waterfall are 1) return of principal and 2) a different preferred return up to a threshold rate of return (8%, for example). These two tiers can be interchangeable, depending on the deal Operating Agreement. Generally, both the GP (the Sponsor) and the LP (EQUITYMULTIPLE and its investors) will receive return of capital upon capital event (sale or refinance), all other cash flow will go toward the preferred return, and then a portion of the remaining sale proceeds (if necessary) until both the GP and LP get to the 8% return threshold.
A Step Further: Different Arrangements of Preferred Return
As mentioned previously, preferred returns can be structured in a number of ways.
- Preferred Equity: again, this arrangement corresponds to a position in the capital stack, and typically entitles an investor to both their return of capital (principal) and a fixed-rate return before any capital is returned to the sponsor and other equity investors.
- Common equity – “true” pref: in this arrangement, the investor will receive a preferred return before any capital is returned to the sponsor; the investor will receive profits up to a predefined percentage rate of return.
- Pari Passu Pref: In latin, “Pari Passu” means “on equal footing”. In this arrangement, the sponsor and the investor are treated equally up until the rate of return threshold is met for each. After this threshold is met, the sponsor’s promote will kick in for all remaining profit distribution.
A Few Real-World Examples:
- Preferred Equity: Our Getaway Leased Cash Flowing Campground deal serves as a straightforward example of this type of structure. Each EQUITYMULTIPLE investor is entitled to a non-compounding 13%* annual return for three years, directly after senior debt service, and before the Sponsor receives any cash returns. Notice how this corresponds with the the capital stack diagram on our homepage, with preferred equity sitting directly atop senior debt.
- Common Equity with True Pref: Let’s look at our Bushwick Mixed-Use Redevelopment Project. The order of profit distribution is as follows:
- 100% pro rata to investors (including the Sponsor and LPs) until they have received a cumulative 10% preferred return
- Return of investor capital contributions, pro rata
- 30% to the sponsor and 70% to investors (including the Sponsor, such that the Sponsor receives a share of the 70% in addition to their 30%)
- Common Equity with Pari Passu Pref: Let’s look at our College Station, TX Student Housing Acquisition Project. The order of profit distribution is as follows:
- 100% pro rata to investors and the Sponsor until all have received an average 8% annual return across the term of the project
- 100% pro rata to investors until all capital contributions have been returned.
- Thereafter, a straight 65% to investors and the sponsor pro rata, and 35% wholly to the Sponsor.
The bottom line: the distribution waterfall for any given project may be fairly opaque at first glance. Hopefully keeping these concepts in mind will help you identify the payment structure, but we’re always available to answer questions to ensure that you have a clear picture. For any offering wherein preferred return comes into play, the specific terms will be laid out in the investor documents.