I very often get asked to look at deals on behalf of investors. And I’ll very often get a comment like this: “I think it is a good deal because the operator is offering me a 10% preferred return!” It is understandable why an investor would say something like this, but there are clearly two misunderstandings at play.

The first misunderstanding relates to what a preferred return is. In the typical real estate transaction, preferred returns are offered to investors to ensure they receive a return on their capital BEFORE the operator of the deal (deal sponsor) takes a promoted interested (a promoted interest is an excess share of profits that deal sponsors are rewarded with in the event a deal performs well.)

A preferred return is NOT guaranteed minimum interest payment: just because a deal consists of a preferred return, it does not mean that the operator is committing to distributing that money (say 10% annually) to his/her investors.

In fact, in the current investment climate, you’d be hard-pressed to find a transaction in which the year 1 annualized returns are 10%. It’s usually not even possible for a sponsor to commit to distributing 10%, as the underlying asset is simply not producing that much cashflow.

The preferred return (or “pref” colloquially) simply represents the fact that the sponsor will not take his/her excess profits until the investor receives: 1) all of their capital back 2) a 10% IRR on their capital (assuming the preferred return is 10%). Then, once the investor has received those two things, could the sponsor start to take his/her promoted interest.

In general, sponsors will make distributions as they have the capital available. And preferred returns are often paid only when the investment is exited, in year 3-10. If the preferred return was not paid through cashflows during the life of the investment, it accrues (and compounds), and is paid at a later date when a capital event occurs.

The upshot of all of this is that you can never use the preferred return as a gauge for the quality of the transaction. Good transactions are built on solid deal-level fundamentals. In the above example, the investor thought that the deal was good because the sponsor was offering a high pref. But the pref won’t matter if the deal does not make money. And the sponsor is not on the hook to pay any investor a pref, if the deal does not perform.