Becoming a passive real estate investor in an apartment syndication can be a profitable endeavor. However, provided you look for deals structured with alignment of interests.  An example of aligned interests is the preferred return: you, as the passive investor, are the first to receive any profits before the general partner is paid.  For example, if there is an 8% preferred return, you would receive an 8% return for a year before the general partner gets their return.

About Preferred Returns in Real Estate

In a real estate syndication, the general partner, also known as the sponsor or lead investor, is the one who puts together the deal.

As a general partner, they are responsible for finding a property that satisfies their investment criteria and determines the best way to recondition the property following the business plan.

And then, as the property undergoes renovation, they also manage it until the project is complete.  The general partner is also the one who receives the calls at any time of the day or night concerning any emergencies with the property.

Put it all together, and it adds up to a lot of time, energy, and stress that many investors don’t want to deal with; therefore, they simply choose to become passive investors.

Passive investors help put up the capital for the real estate investment, essentially becoming limited partners.

As limited partners, they are relieved from having to deal with any of the daily decisions that must be made regarding the purchased properties. However, they get to benefit from the expertise of the general partner in finding real estate with the revenue potential to which they get to share in the profits.

If they enter a preferred return agreement, which would be outlined in the initial contract, they get paid first, often between 6% and 9%.  After the prescribed percentage has been distributed to the limited partners, the general partner is then free to take their cut of the profits from the remainder of the income.  This is again outlined in the agreement between the general partner and limited partners and is often 70-30 split where 70% is distributed to the limited partner and 30% to the general partner.  This forms an alignment of interest where the general partner is only paid on a successful investment for the limited partners.

Why a Preferred Return?

The Importance of a Preferred Return to Passive Investors

In short, a preferred return provides limited partners greater confidence they will receive a targeted return from the capital investment.

In fact, if the property’s income is not greater than the preferred return, it means the general partner will not receive any profits from the earnings.  Hence, the general partner has a greater incentive to select real estate with the greatest potential for high returns so they can share in the profits.

The Importance of a Preferred Return to General Partners

When a general partner has a track record of achieving the preferred return they initially projected, it helps foster confidence in other passive investors. This is especially true if the general partner also continuously exceeds the return they promised.

This, in turn, provides the general partner with an additional way to attract other limited partners for future real estate investment deals.

How a Preferred Return Works 

Implementing a preferred return can be done in various ways, and it can also vary from syndication deal to syndication deal. In fact, a general partner can get just about as creative as they’d like when structuring how the income and capital gains from the property will be distributed to their other investors.

For instance,  compounding interest can be used to structure your preferred return, which means any interest earned from the invested capital will be allowed to grow over a certain period, which can be yearly, quarterly, monthly, or continuously, and then distributed to the limited investors. If there are any other amounts earned during or before this time that have yet to be paid, they will also earn compound interest.

Or the preferred return may be structured as a preferred equity investment, in which case, when the real estate investment is sold or refinanced, the preferred equity investors will be first to be rewarded a return on the capital. They will also be rewarded with a return on their initial investment.

And then there is the waterfall capital structure, which is the simplest type of preferred return structure used in a syndication deal. In short, waterfalls simply spell out how the various classes of investors will be paid from the returns.  However, there are also various considerations following this type of structure that govern when the returns are distributed to specific investors.

Some other common ways to structure a preferred return include:

• Cumulative and noncumulative structured returns – dictate how any unpaid monies remaining at the end of one period will be paid. A cumulative structure allows any unpaid earnings leftover at the end of the period to be carried over to the next period, while a noncumulative structure does not.
• Pari-Passu structured return – is when the lead investor and the passive investors receive the same preferred return simultaneously, meaning the passive investors do not receive preferential treatment when it comes to the distribution of capital. However, the lead investor and the passive investors are usually only treated equally until the return reaches a specific percentage, and then new rules for the distribution of capital apply.
• Lookback provision – dictates that if at the end of the established return period, the passive investor looks back, and he or she has not received the rate of return that the lead investor outlined, the lead investor will compensate the passive investor with a fraction of their distributed profits, so the passive investor receives their targeted rate of return.
• Catch-up provision – is similar to the lookback provision, except all of the distributions go to the passive investor until the targeted rate of return has been reached, and then the returns are split as outlined in the agreement.

An Example Scenario of How a Preferred Return is Beneficial to Investors

For an example of how a preferred return benefits passive investors, let’s say the investor is given a 10% preferred rate of return per year on a cumulative structured return.  Let’s say, this investor’s investment is $100,000.  This means they should get $10,000 to hit the 10% preferred return. However, there are only enough profits to pay a 5% return, so the amount paid is $5,000 in the first year.

The 5% that was not paid would roll over to the next year, ramping the preferred return from 10% to 15% on year 2.

Now let’s say the 15% return in the second year still isn’t enough to satisfy the return payout, then the amount still owed would be accrued in the third year, and so on, meaning in scenarios where the preferred return falls short in the first few years, the passive investor can catch up in following years.

This is common for the value-add strategy.  Often the first year sees lower returns as renovations are being made on the property, allowing for higher returns in the following years.

In the end, a preferred return when investing in real estate helps the passive investor get paid first, before the general partners.  It fosters an alignment of interest where the general partner is paid on a successful investment for the limited partners.

If you are interested in learning more about passive investing in apartment syndications schedule a call with us!