Preferred Returns, Waterfalls & Hurdles

October 5, 2017

The order in which equity investors get paid – the “distribution waterfall” in industry parlance – is one of the most critical concepts in real estate investing. Unfortunately, distribution waterfalls can get fairly 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, mezzanine debt, preferred equity (or “pref equity”) and common equity (sometimes referred to as “JV equity”, or simply “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 illustrating where preferred equity sits relative to senior debt and common equity).

Preferred Equity return of capital and preferred returns gets paid out before Common Equity. Generally, during the term of the project, preferred equity investors are entitled to a contractual percentage return out of current cash flow (current return of 8%, for example). Projects with an accrued interest can offer payments over the life of the project if there is enough current cash flow, but otherwise accrues and is paid out upon asset sale (another 8%, for example, on top of the current return).

Upon a capital event (sale or refinance), cash flow is distributed according to the distribution waterfall described in the deal’s Operating Agreement. After debt is paid off, preferred equity will receive their distributions following this tier: 1) current return, 2) return of principal and 3) accrued return. Any remaining cash flow will go towards the Common Equity partner’s return of capital and remaining profits. In some agreements, preferred equity may participate in that share of profits.

On the other hand, a preferred return refers to a fixed-rate return percentage, which can be associate whether you are a Preferred Equity or Common Equity investor.

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 preferred return before any capital is returned to the sponsor and other equity investors.
  • Common equity with 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:

  • Current Preferred Return: 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 capital stack diagram on our homepage, with preferred equity sitting directly atop senior debt (and mezzanine debt, if any).
  • Current & Accrued Return:  Boston Condo Development offers both an 8% current return during the term of the project and an additional 9% accrued portion upon the sale of units. Again, this is before the Sponsor receives any return of principal or profits.
  1. Accrued 10% preferred return to Common Equity members (includes the Sponsor, EquityMultiple investor, and existing LPs), pro rata
  2. Return of investor capital contributions, pro rata
  3. 30% to the sponsor and 70% to members (this portion includes the Sponsor, such that the Sponsor receives a share of the 70% in addition to their 30%–this is called the ‘promote’)
distribution waterfall example

A distribution waterfall example from an EquityMultiple offering circular


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. Understanding these concepts, and paying close attention to details, can help you avoid unpleasant surprises when distributions occur.

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