What is a Preferred Return in Private Real Estate Investing?

A preferred return in private real estate investing is the minimum return an investor must receive before an investment manager can earn a performance fee. The preferred return is typically between 6% to 9% in real estate investing, depending on the risk of the investment. You can think about this as an interest payment on your money as it accrues in the same way, but it is not a guaranteed payment.

Performance fees align the interests of the real estate manager with those of the investor. Guaranteed fees such as annual asset management fees pay for real estate manager salaries and to keep the company’s lights on, but the performance fee, which is typically the largest part of their compensation, is what motivates the manager to deliver outsized returns to investors.

Because of this, real estate managers are incentivized to be efficient with cash and return capital to pay down the preferred return as quickly as possible so they can begin to share in the upside. A sensible real estate manager will not undertake a project if they don’t believe they can significantly outperform the preferred return.

How a Capital Account Balance is Essential to Understanding the Preferred Return

A capital account in a real estate investment is essential to understanding the preferred return. A capital account is an individual account of each person’s money as it rolls up to the overall investment. At Origin, we provide real estate funds in which hundreds of individuals invest. A capital account is the way that these individuals can understand their holdings and how their investment grows over time.

Capital account management is typically handled by the investment’s administrator or an outside accounting firm and the account details don’t appear on investor statements. A capital account balance decreases as capital is returned and increases as the preferred return accrues. A capital account balance is calculated by taking the unreturned capital balance and multiplying it by the preferred return prorated for a specific duration.

For example, let’s say $500,000 was invested on January 1 and the preferred return is 8%. On June 30 of that same year, the capital account balance will be $520,000. This is not what the manager owes, but simply shows the amount of money the manager would have to pay the investor before receiving a performance fee. In a typical real estate investing waterfall (a methodology that defines the way in which cash distributions are allocated across the manager and the investor), the preferred return gets paid first and then the investor gets their capital back. After that, the manager will share disproportionately in the profits because they have generated a return more than the preferred return.

How Fair Market Value Comes into Play

Many investors believe that the preferred return is a distribution that impacts their fair market value; however, this is not the case. The fair market value of an investment is reported on investment statements and is the value of your pro-rata ownership in the properties as of liquidation. The fair market value decreases as distributions are made and increases as the value of your investment appreciates. It is possible that the fair market value of the investment is higher or lower than the capital account value. Expanding upon the example above, the fair market value of the investment might be $550,000 which means the manager would earn a performance fee if the investment were liquidated today. On the other hand, the fair market value might be $500,000, which means the minimum hurdle would not be met and the manager would receive no performance fee if liquidated.

Preferred Return in Practice

It’s important to understand that the preferred return continues to accrue even when partial payments are made to an investor. Assuming the same capital account balance of $520,000, if the manager makes a payment of $250,000 on June 30, then the unreturned capital balance will be $270,000. Generally speaking, unless specified otherwise in the operating agreement, the distribution, or investor payment, is first used to pay down the preferred return of $20,000 and the remainder, $230,000, is used to pay down the unreturned capital balance of $500,000. The new unreturned capital balance is now $270,000 and the preferred return will accrue on this amount going forward.

If the manager instead sells the asset on June 30 and returns $600,000, the preferred return and the unreturned capital balance will both be satisfied, and the manager will typically be entitled to receive 10% to 30% of the $80,000 gain above the preferred return.

It is possible that an investment is being wound down and, consequently, the capital account balance is positive. Continuing the example above, let’s assume that the $500,000 investment is liquidated on June 30 for $400,000. This capital would first be used to pay the preferred return of $20,000 and then reduce the unreturned capital balance of $500,000. However, the remaining capital, $380,000, is not enough to satisfy the entire unreturned capital balance, leaving the investor with an unreturned capital balance of $120,000. This is not money the manager owes, as the investment has been completely liquidated and this amount would be taken as a loss on the investor’s tax return.

To summarize, the preferred return is simply a rate of return tier that defines various profit splits. Once a capital account balance reaches $0, a fund manager typically starts participating in profits. Although the preferred return is not guaranteed, performance-based fees align the manger’s interest with those of the investor. On the other hand, the fair market value of an investment has nothing to do with the preferred return and is a measurement of increases or decreases in the value of the investment. All definitions aside, investors should have a sense of what capital account accounting is all about, but fair market value accounting is much more relevant for understanding what an investment is worth, so growth can be tracked over time.