What is Preferred Return?
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As a multifamily investor, one of your most important considerations is the return on investment (ROI). This is typically expressed as a percentage, and is calculated by dividing the expected annual return by the total amount invested.
Generally speaking, higher returns are preferred.
Investors like you seek to maximize their return when investing.
There are several strategies you can use to maximize your returns. For example, you can look for properties with higher rental rates or more units. You can also look for properties in markets with strong rental demand. Of course, you should factor in all associated costs when calculating the expected return on an investment.
So how does preferred return figure in to this equation?
What is a preferred return?
A preferred return, or pref, is an agreement between investors and project owners that defines the claim of profits given to investors. This agreement allows investors to receive returns up to a certain percentage, after which any additional profits are distributed among the other investors as previously agreed.
Here's another way of understanding it, a pref is the minimum return that investors get before the syndicators who to put together the deal get paid.
This is also expressed as a percentage.
So if you hear someone talking about an eight pref, it means that the investors themselves would get 8% before the people who put together the deal would would get any money on the deal from the operational cash flow.
Are these preferred returns always considered a good thing?
They can be a good for LPS.
People tend to like prefs for obvious reasons.
But what we have found at Nighthawk is, we want to be aligned with our investors. In order to be aligned, prefs might be a bad thing.
For instance, let's say there's a property that you've given out an 8 pref, and it consistently over the first three or four years has returned 5, 6, or 7 percent to the investors. Not only is it not met that 8% hurdle, but it's actually creating a deficit.
In that world, it's very possible for the syndicators to become unmotivated by the asset and not work as hard on executing their business.
As a result, they really don't make that property the best it can be.
The syndicators aren't working as hard on making it super valuable.
For that reason, we have historically stayed away from prefs.