There are many ways a multifamily sponsor can put their investor's interests first in a syndication. One of those ways is a preferred return. A preferred return is simply a waterfall that provides 100% of returns to the limited partners up to a certain point. This means for example that if an investment fell short on returns and only provided a 7% return on the money invested, that the entirety of the returns would go to the passive investors if there was a 7% preferred return.
What is a waterfall return structure?
A waterfall return is simply a tiered return structure that incentivizes the active sponsors on a real estate syndication to meet and exceed the projections for that investment. It accomplishes this by providing higher returns to the sponsors as certain return levels are met. The graphic below gives an idea of what a waterfall structure could look like on a syndication deal. The first 7% of returns would go entirely to the passive investors, then the profits would be split 70/30, then finally a 50/50 hurdle might be present if the investment exceeds projections by a certain specified amount.
How is the preferred return calculated?
Let's use the structure shown in the figure above and assume we have $100,000 in profits to disperse on an investment that has $500,000 of equity. The first 7% (or $35,000) would go to the passive investors as the preferred return. Then, the remaining $65,000 would be splits 70/30 being the passive investors and the sponsors results in an additional $45,500 in returns being provided to the passive investors. As mentioned above, the 50/50 hurdle would only be tripped if the investment exceeded projections at a level specified in the investment summary.
What is the typical percentage for a preferred return?
The answer to this question is highly dependent on the market and deal. However, many preferred returns for investors are in the 6-7% range. This not only gives investors the large majority (likely all) of the returns from cash flow, but it also constitutes more than a third of the total expected return which is why a preferred return is a great way to mitigate low or no returns for passive investors.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."