Preferred Returns: The Difference of a Single Letter

In most passive
investments, the sponsor commits to paying the investors a specified percentage of their investment per year before the sponsor can start to collect performance fees. As such, these payments are referred to as “preferred returns” and the payment relative to the investor’s capital is the “preferred return rate”. The preferred returns are generally due to be paid periodically throughout the investment period when there is sufficient cash flow. If there isn’t, any unpaid amounts are generally accumulated and paid at a later date when the cash flow increases or after a liquidity event such as the sale or refinance of a property. Preferred returns can be defined by the sponsor as either “return on capital” or “return of capital”, which is a small typographical difference but leads to very different financial outcomes. This post will describe the difference between these two types of returns in detail.

Return on Capital vs. Return of Capital 

If the sponsor defines the preferred return distributions as returns on capital, then the amounts received by the investor are classified as profits to the investor, which are taxable, though often depreciation and other losses can be used to offset these gains. The value of the preferred distribution will be constant over the investment period unless there is an event such as a sale or a refinance of a property that results in a return of some portion of the investor’s original investment. If no such event occurs, the value of the preferred distributions will simply be the preferred return rate times the amount of the original investment. If a partial return of capital occurs sometime during the investment period, then the preferred return will generally decrease in proportion to the fraction of the investor’s capital that has been returned.

On the other hand, if the preferred returns are defined as returns of capital, then the distributions are not taxable since they represent the fractional return of the investor’s original investment. For this reason, the sponsor will also deduct such distributions from the investor’s original investment amount to arrive at a value known as “unreturned capital balance”, “net capital contribution”, or other similar term. Since the preferred return rate is applied to the resulting capital balance, the dollar value of the preferred returns will decline over the investment period.

Which one is more investor-friendly?

 So, which is better – return on capital or return of capital? The answer depends on the specific terms of the deal and the investor’s own financial situation. However, if all of the other deal terms are the same, then return on capital is better for the investor while return of capital disproportionately benefits the sponsor at the expense of the investor. An example will help to clarify this conclusion.

Assume that a sponsor is offering a preferred return of 7% per year on a cash-flowing investment. The distribution waterfall specifies that during the operational period of the investment the accumulated preferred returns will be paid first, after which the investor and sponsor split any excess operational cash flow with 70% to the investor and 30% to the sponsor. When a profitable sale or refinance takes place, any accumulated, unpaid preferred returns will be paid first, followed by payment of the investor’s unreturned capital balance. Any remaining funds from the sale or refinance are again split 70/30 between the investor and sponsor. In this example we’ll assume that the investor invests $100,000 in this deal and the sponsor sells the property after a five-year hold for $180,000 (proportional to the $100,000 investment) after all fees, expenses, and paying off the debt and other higher-priority obligations in the capital stack. During the five-year hold, the investment produces excess cashflow of $7,000 per year, sufficient to pay the preferred returns and avoid accumulation. 

In the case where the sponsor defines the preferred return as return on capital, the cash flows to the investor and sponsor are shown in Table 1:

Table 1: Preferred returns are defined as Return On Capital.

In this example the investor receives the full amount of her preferred return each year for a total of $35,000. Since the cashflow from the property was just enough to pay the preferred returns each year then there was no excess operational cashflow and thus no split payments to the investor or sponsor during the five-year hold. After the sale she receives all of her invested capital back ($100,000) and then splits the remaining profit ($80,000) with the sponsor. As a result, our investor had a total pre-tax return of $91,000 over 5 years resulting in an internal rate of return of 15.2% and an average annual return (AAR) of 18.2%. The sponsor received no performance fees during the hold period and received $24,000 as a result of the profitable sale.

Now consider the same terms and conditions but where the sponsor defines the preferred return to be return of capital in Table 2:

Table 2: Preferred returns are defined as Return Of Capital.

In this situation, the $7,000 per year operational cash flow is just sufficient to pay the full amount of the investor’s preferred return in the first year, and there is no excess operational cash flow. But since the preferred distribution to the investor is considered a return of capital, this amount is deducted from the original investment to calculate the unreturned capital balance in year 2. At the end of year 2 the preferred return owed to the investor is $6,510 (7% times the unreturned capital of $93,000), and this amount is deducted from the capital balance to get the new balance for the following year. The excess operational cashflow of $490 ($7,000 – $6,510) is split 70% to the investor and 30% to the sponsor. This process continues for the remainder of the five-year investment period, at the end of which the property is sold. Over the course of the investment, our investor receives total preferred returns of $30,431, as well as $3,198 from her share of the excess operational cashflow for a total of $33,629. Upon sale, she receives an additional $146,880 (($180,000 – $69,569) x 70% + $69,569). The total pre-tax return to our investor in this scenario is $80,500 over 5 years corresponding to an IRR of 13.9% and an average annual return of 16.1%. Meanwhile the sponsor received performance payments of $1,371 during the holding period and $33,129 on sale of the property for a total of $34,500.

Bottomline: Passive investors should look for Return on Capital syndications (if all else is equal)

Tables 3 and 4 below summarize the returns in these two scenarios from the investor’s and the sponsor’s perspectives, respectively. Given identical terms and conditions, Table 3 shows that our investor was worse off in the scenario where the sponsor labeled the preferred returns as return of capital. Her total pre-tax return was 8% less, and her investment performance measures of IRR and AAR were materially reduced.

Table 3: Summary of Returns for the Investor

On the other hand, Table 4 shows that our hypothetical sponsor made 44% more when the returns were defined as return of capital. Not only does this sponsor benefit disproportionately by employing a return-of-capital framework, but they also begin receiving performance fees years earlier, prior to the sale of the property. Even if the eventual sale wasn’t profitable and our investor lost some of her principal, the sponsor would still have received some performance payments! So, in addition to being a financial gain for the sponsor, classifying preferred distributions as return of capital also reduced risk to the sponsor by providing some performance payments prior to the sale when the profitability of the investment is determined.

Table 4: Summary of the Returns for the Sponsor

From this example, we can say that given two deals with identical terms other than the way preferred returns are defined will lead to significantly different outcomes for the investor and the sponsor. The return-on-capital framework favors the investor while return of capital benefits the sponsor. Of course, when comparing two real estate investment deals, other terms, such as the preferred return rate or the split, might also differ in which case a careful analysis of all of the terms would be required to understand the relative merits of the two deals. 

How to determine which type of preferred return you will get

Now that we have established that the two different definitions of preferred returns can result in materially different outcomes, how do you know which variant the sponsor is offering? Unfortunately, the sponsor may not be clear about this in the offering summary or in a presentation. The answer is in the offering documents, which may include the Private Placement Memorandum (PPM), the Operating Agreement (OA), and/or the Limited Partnership Agreement (LPA). But the wording and clarity varies considerably from sponsor to sponsor and even between offerings from the same sponsor. An example of a recent, clearly worded excerpt is:

4.2(a) Distributions of Distributable Cash:

(i) 8% Preferred Return. First, 100% to the Limited Partners, to the extent of and in proportion to their respective Unpaid 8% Preferred Return amounts;

(ii) Return of Capital. Second, 100% to the Limited Partners to the extent of and in proportion to their respective Unreturned Capital Contributions; and

(iii) 70/30 Carried Interest. Thereafter, 70% to the Limited Partners, pro rata in proportion to their respective Investment Percentages, and 30% to the General Partner.

where 8% Preferred Return means:

a sum equal to 8% per annum on the daily ending balance of the Partner’s Unreturned Capital Contribution,

Unreturned Capital Contribution means:

the cumulative sum of Capital Contributions by the Partner as of the applicable determination time, reduced by the cumulative sum of distributions to the Partner pursuant to Section 4.2(a)(ii)

In this example, the distribution waterfall 4.2(a) specifies that the 8% Preferred Return has first priority. The capitalization of this term means it is defined elsewhere in the document. When we review that definition, we find that the 8% Preferred Return depends on the Unreturned Capital Contribution. Reviewing the definition for that term makes it clear that only explicit Return of Capital payments, 4.2(a)(ii), such as from a refinance or sale of a portfolio property, affect the basis for the preferred returns. The returns due to the 8% Preferred Return and the 70/30 Carried Interest are not used to calculate the Unreturned Capital Contribution, so the preferred returns in this example represent returns on capital.

It’s important to understand that subtle changes in the wording of the distribution waterfall can change the type of preferred distribution. In the example above, if the definition of Unreturned Capital Contribution specified that the Capital Contributions were “reduced by the cumulative sum of distributions to the Partner pursuant to Section 4.2(a),” (i.e. not specifying subsection ii), then the 8% Preferred Return would be deducted from the Capital Contribution, thus making the preferred distributions a return of capital.  

Conclusion

As can be seen, small changes in the definitions used in the offering documents can change the form of preferred returns with all of the associated financial implications. Unfortunately, many offering documents are less clear than the above example. And sponsors may change the type of preferred returns between investment offerings and may not highlight these changes in presentations to their potential investors. Because of this, it is vital for investors to carefully review the offering documents – in particular the plan of distribution and associated definitions – in order to understand which type of preferred return is being offered and to determine the implications for their own financial situation. If you still have questions on the type of preferred return being offered or on any other matter after you have reviewed the documents, you should ask the sponsor for clarification and/or seek professional legal advice.