If you start looking at Real Estate syndications to passively invest capital into, you’ll likely run across offerings that have “Preferred Returns”. What are preferred returns, you ask?
Preferred returns are shares that sit higher up in the capital stack when it comes to distributions, usually right behind the lender. Preferred returns usually get paid ahead of General Partner/Sponsor splits are paid. In plain English, they have priority in distributions from cash flow and sale proceeds ahead of everyone else, except the lender.
Let’s assume you look at a deal with the following pay out structure:
7% Preferred Return
70/30 until 15% IRR
50/50 after 15% IRR
What the heck does that mean?
Let’s break it down:
7% Preferred Return: This means that the sponsor wouldn’t get any cash flow or fees on the back end of the sale/refinance until you hit at least 7% return.
70/30 until 15% IRR: After you pass the 7% IRR as previously mentioned, the General Partner will charge 30% as a fee out of the profits until you hit 15% IRR.
50/50 after 15% IRR: If the deal does very well and goes over 15% IRR, the sponsor will charge 50% of the profits for anything over 15% IRR.
Keep in mind that IRR is annualized, meaning that would be 15% annualized over the duration of the holding period. Promote structures such as that incentivize the General Partner/Sponsor to perform as best as possible to exceed 15% returns (annualized) for you as an investor, because that’s where they’d have the highest returns. It aligns the investor and sponsor interest towards maximizing returns.
Having said that, those are just example returns, as every deal is different depending on the market and risk profile.
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