What is a Preferred Return?
A preferred return is a distribution priority within a real estate investment that gives investors the right to receive a specified return before the sponsor or general partner participates in certain profits. Often expressed as an annual percentage, such as 8%, a preferred return establishes distribution priority but does not guarantee that investors will actually receive that return.
One of our newer investors, Bill, left me a voicemail yesterday.
“Hey, uhh, Paul, I’ve got a question on my distribution. Can you call me?”
I knew exactly what Bill wanted to discuss.
I called Bill back after lunch, and it was precisely as I had predicted.
“Hey Paul, I got my first distribution. Something was bothering me about it, so I calculated it...and it seems short of what I expected. I was thinking it would be based on my 9% annual preferred return. But it looks closer to 6% annualized.”
What is a Preferred Return and How is it Different from an Actual Return on Investment?
In short, it’s a private equity term used to describe the priority of cash flow within a deal structure. It’s an important term for passive real estate investors to understand.
A preferred return, often called a pref, is a provision in a real estate investment’s distribution waterfall that gives one class of investors priority in receiving investment profits before another class, typically before the sponsor or general partner participates in a disproportionate share of the profits through a promote or carried interest.
The preferred return is generally expressed as an annual percentage, such as 8%, although it can also be structured around an IRR, equity multiple, or another defined return hurdle. It is usually calculated on a specified capital base, often the investor’s contributed or unreturned capital. Available cash from property operations, refinancing, or the eventual sale may be distributed to the preferred investors until the required return threshold has been satisfied. Only after the applicable preferred return hurdle has been met does the remaining cash move to the next level, or “tier,” of the waterfall, where profits may be shared differently between investors and the sponsor.
Importantly, a preferred return is not the same as a guaranteed return. It establishes the order in which available distributions are allocated; it does not guarantee that the investment will generate enough cash or profit to actually pay that return. The specific operating or partnership agreement determines exactly how the preference works, including whether unpaid preferred returns accumulate from year to year, whether those unpaid amounts compound, whether capital must be returned before or after the preferred return is paid, and how profits are divided after the preferred return hurdle has been achieved.
A preferred return is a hurdle, not a prediction of what an investor will actually earn in a given year. It is the level at which the profit share between investor and sponsor begins.
In a common structure, available cash is distributed to investors until the applicable preferred-return hurdle has been met, before the sponsor begins receiving its promote.
The governing documents define what counts as distributable cash, typically what remains after property expenses, debt service, fees, and required reserves.
If the preferred return is cumulative, unpaid amounts carry forward and must be satisfied before the sponsor earns its promote, assuming sufficient distributable cash is ultimately available. Cumulative is not the same as compounding: accrued amounts may or may not themselves earn additional preferred return, depending on the agreement.
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Why is the Preferred Return Important for Investors?
The sponsor typically has greater access to operating information and substantially more control over execution than passive investors do. And the sponsor has authority over the activities (property management, etc.) that will cause the project to perform according to its predicted outcomes.
Investors are trusting the sponsor to accurately project these numbers and to follow through to see them come to pass. So the preferred return is a gesture on the part of the sponsor to show his or her confidence in the projected outcomes.
Up to the preferred-return hurdle, available cash is generally distributed to investors before the sponsor earns its promote. If the deal returns at or below this cumulative level, the sponsor generally does not earn its promote, though it may still receive returns on its own invested capital and any contracted fees.
A preferred return can help align incentives, because the sponsor's promote generally increases only after investors clear the applicable hurdle.
It is important to note that offering a preferred return does not necessarily mean there is an alignment of interest with the sponsor and investor. The sponsor benefits if the project does well, but the investor takes the risk if it doesn’t. This can incentivize risk-taking on the sponsor side. The sponsor can offset this risk by putting their own cash into the project. We make sure the operators we invest with put substantial amounts of their own cash into their projects. In addition, we as Wellings Capital principals invest our own money into the deals.
An Example of Preferred Return
Let's assume an investor contributes $100,000 to a fund with a 9% cumulative, non-compounding preferred return and an 80/20 split above the pref, with investors receiving 80% and the sponsor 20%. The preferred return is calculated on the original $100,000 capital balance.
How much should investors expect to receive and how would the cumulative preferred return factor into these calculations?
If distributable cash flow is 5% in year one, investors will receive all 5% and accrue 4% (9% preferred minus 5% actual) toward a future distribution.
If distributable cash flow is 7% in year two, investors will receive all 7% and accrue 2% more (9% preferred minus 7% actual) toward a future distribution.
If distributable cash flow is 8% in year three, investors will receive all 8% and accrue 1% more (9% preferred minus 8% actual) toward a future distribution.
In year four, assume the fund refinances and sells several assets which creates a distributable cash flow of 18%. Investors would receive the first 9% since that is the annual preferred return level. But years one through three left a cumulative make-up of 7% (4% + 2% + 1%). So the investors would get the next 7% of the distributable cash in that year.
Above that level there would be an 80/20 split. So with the 18% cash flow minus the 16% paid to investors, there would be 2% left for the 80/20 profit share. The first 1.6% (80% of 2%) would go to investors. The remaining 0.4% (20% of 2%) would go to the sponsor.
In year five, assume the distributable cash flow is 15%. In that case, the first 9% would go to the investors and the remaining 6% would be split 80/20.
Caveats and Exceptions
Please note that this example doesn’t take into account the potential dwindling principal in some scenarios. The outstanding principal is the basis for the preferred return calculation, and if the principal is reduced through payments above the preferred level, then the preferred return would be calculated as a percentage of this new number. The governing documents determine how this works for a given deal.
Note that this example also does not take into account a non-cumulative preferred return. Some syndications only do a preferred return for the current year of cash flow distributions, which means there is no make-up.
Also note that some sponsors have a catch-up provision. This means that after investors receive their preferred returns, all returns above that level are paid to the sponsor until it has caught up to a pre-determined level. In this case, the split on the total deal might be determined to be 80/20 for example. So after investors receive the preferred return, the sponsor is paid all distributions above that level until the total split reaches 80/20.
It is important to read the PPM and ask the sponsor for clarity on these terms to be sure you understand everything, before going down the road of investing. Because these provisions can materially change investor economics, investors should understand the actual waterfall rather than relying only on the headline preferred-return percentage.
Preferred Return vs. Preferred Equity
These terms sound alike and are frequently confused, but they describe two different things.
Everything above describes a preferred return — a provision that sets the order of distributions within an equity investment.
Preferred equity is different. It is a distinct position in the capital stack, sitting between senior debt and common equity. Preferred equity investors hold priority over common equity for both cash flow and return of capital, and their position often carries separately negotiated protections such as approval rights over major decisions, mandated reserves, or forced-sale rights. Common equity typically absorbs losses first, creating a cushion beneath the preferred equity position.
The distinction matters: a preferred return tells you how distributions are prioritized among equity investors. Preferred equity tells you where your capital sits in the capital stack and what protections come with it. An investor can have a preferred return without holding preferred equity.
At Wellings Capital, we invest preferred equity and JV equity alongside experienced operators. You can read more in our guide to preferred equity terms and definitions.
If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call.
Frequently asked questions
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No. A preferred return determines the priority of distributions, but it does not guarantee that the investment will generate enough cash to pay that return. If the property or fund underperforms, investors may receive less than the stated preferred return.
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It depends on whether the preferred return is cumulative. With a cumulative preferred return, any unpaid amount generally carries forward and must be satisfied before the sponsor participates in the applicable profit split. With a non-cumulative preferred return, the shortfall generally does not carry forward.
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A preferred return is a hurdle or distribution priority, while cash-on-cash return measures the cash actually distributed to an investor relative to the capital invested. For example, an investment could have a 9% preferred return but distribute only 6% in a particular year.
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A preferred return is typically stated as an annual percentage and calculated on a defined capital balance, often the investor's contributed or unreturned capital. If part of the investor's principal is returned, future preferred return calculations may be based on the reduced outstanding capital balance.
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After the preferred return hurdle has been satisfied, additional profits generally move to the next tier of the investment's distribution waterfall. Those profits may then be divided between investors and the sponsor according to an agreed-upon split, such as 80% to investors and 20% to the sponsor.
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A catch-up provision may allow the sponsor to receive a greater share, or even all, of certain distributions after investors receive their preferred return until a predetermined overall profit-sharing ratio is reached. Investors should carefully review the offering documents to understand whether a catch-up provision applies.
DISCLAIMER: Past performance is not indicative of future results. There is no guarantee that any forecasts or projections will be achieved. Any investment involves significant risk, including the possible loss of principal. Investors should carefully consider the investment objectives, risks, charges, and expenses of any Wellings Capital Management, LLC (“Wellings”) investment program. Offering documents containing this and other important information are available by calling 800.844.2188, emailing invest@wellingscapital.com, or visiting wellingscapital.investnext.com.
The information in this article is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities in any jurisdiction where such an offer or solicitation would be unlawful. Wellings does not provide tax, legal, or accounting advice. Investors should consult their own advisors regarding any investment. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete and thus should not be relied upon as such.
