Preferred Return Explained
If you are relatively new to the world of commercial real estate investing (including multifamily investing), you might have come across terms such as ‘preferred return’ and ‘waterfall structure’. Knowing exactly what these terms mean will help you to make better investment decisions.
Preferred Return (The 'Pref')
The ‘pref’ describes the percentage of profits that will first be paid out to preferred investors (Limited Partners) before the sponsors (General Partners) or anyone else gets paid. This varies from project to project but is often between 7 and 10 percent. Once an investment project generates more than that percentage in profits, the excess amount is split among the sponsors and other investors according to the agreement they signed.
With this type of structure, the sponsors have a strong incentive to make such a property investment produce as much profit as possible, otherwise they might end up getting very little out of it.
Waterfall Capital Structure
A preferred return is often just the first step in what is popularly known as a waterfall capital structure. Waterfalls are profit distribution structures that determine the returns that are paid out to different classes of investors in a real estate project. The first part of the waterfall is usually the preferred return mentioned above. After that, there can be various additional levels that determine how much specific investors will get.
The Bottom Line:
A preferred return gives capital investors an added amount of certainty that they will get a guaranteed rate of return on their investment (though it is not a *guarantee* of payment itself, only payment priority). This is of course on top of other benefits such as mortgage pay-down and capital appreciation.
Waterfall Simulator
Set Investment Terms
Annual Cash Flow (Year 1 - 4)
Distribution Results (Cumulative Pref)
Important Terms:
This simulator uses an **Accrued (Cumulative)** system, meaning unpaid returns carry over. Use the toggle on the left to select if the unpaid portion is **Compounded** (earns interest) or **Non-Compounded** (simple interest).
| Year | Cash Flow | Annual Pref Target | LP Pref Paid | Accrual Balance | LP Promote | GP Promote |
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Enter your investment parameters and annual cash flows, then click "Run Simulation" to see the profit distribution across the years.