What is a preferred return in real estate, and what it is not

A preferred return is a place in the payment queue. It is a defined amount that goes to one class of capital before another receives anything at all. It is an ordering, not a rate a sponsor owes you the way a bond issuer owes a coupon, and that distinction decides most of what follows.

This is written by a developer. Metropolitan Holdings was founded in Columbus in 1998, and we develop, build, and manage the communities we ask people to invest in. Both of our funds publish a preferred return among their terms on the fund terms page, defined there as an accrual payable from available cash flow after debt service and reserves, banded by commitment size. What follows describes the equity case. A debt fund uses the same word for something else, and that has its own section below.

A preferred return is a priority, not a coupon

The word doing the work is preferred. It describes rank, not amount. It sets the order of payment, not the fact of one.

A bond coupon is a contractual obligation. Miss it and the issuer is in default. A preferred return is a term in the distribution section of a partnership’s operating agreement, which says the preferred is payable out of what is available. If the cash is not there, the preferred is not paid and nobody is in default. The agreement is what made the payment conditional.

What accrues in a year when nothing is paid

Accrual is the second word in that definition. Where a preferred is an accrual, a year with no distributable cash does not wipe the amount out. The partnership records that it owes the preferred class that amount, and the balance sits ahead of the sponsor’s economics until cleared.

An unpaid preferred is a claim on future cash, not a receivable you can enforce today. The rate sets the size of the claim. The property decides what you receive.

Debt service and reserves come first

Debt service. The lender’s claim is contractual and secured. Interest and principal on the construction loan, and on the financing that replaces it, are paid before any equity distribution can be prioritised. Where net operating income covers debt service and not much more, there is very little for a waterfall to allocate.

Reserves. Operating reserves, replacement reserves, and the escrows a lender requires for taxes and insurance also sit ahead of distributable cash, and funding them is usually a covenant rather than a choice. What is left is the available cash flow the definition refers to.

What that looks like on a building going up

On a ground-up development there is no cash flow for a long stretch, because there is no building. Land is bought, the site is entitled, and the construction loan is drawn against invoices as the work proceeds. The property produces no rent through any of it, so a preferred return has nothing to be paid from. It accrues, and the balance grows.

Then buildings come out of the ground in phases. The first are finished and occupied while the rest of the site is still under construction, so rent starts before the project is complete, and it meets debt service and reserves first. Once the community is stabilised the construction loan is replaced with permanent financing, or the asset is sold. It is usually that event, not the first leased year’s operating cash, that clears an accrued balance.

So a preferred return in a development fund often pays little or nothing early, accrues through construction and lease-up, and is settled when the buildings are leased or the asset changes hands. That is a feature of development rather than a sign of trouble, and one of the differences between development and buying a stabilised building that the guide to Ohio multifamily investing takes on directly. It is also why development, construction, property management, and investment sit inside one company here, described on the services page: the schedule that decides when a preferred starts being paid is one our own construction team is running.

Where the preferred sits in the waterfall

A distribution waterfall is an ordered list of tiers. Cash fills the first completely before any reaches the second. One ordering, of several you will see:

1. The preferred return. The accrued balance is paid, including amounts unpaid from earlier years.
2. Return of capital. Investors are repaid what they contributed.
3. Sponsor catch-up. The sponsor takes a disproportionate share of the next dollars until it reaches its agreed share.
4. The promote, or carried interest. Everything beyond that is split between investors and sponsor in a stated ratio.

Two cautions. That ordering is not standard: some agreements return capital before paying any preferred, and some run separate waterfalls for operating cash and sale proceeds. Read the one in front of you.

And the catch-up changes what a preferred is worth. A full catch-up means the sponsor eventually receives its promote share of everything, including the dollars that funded your preferred. The preferred still decided who was paid first, which is what matters in a weak outcome. In a strong one it moves the final split less than the tiering suggests. The promote is the last of the lines a sponsor is paid through, and the fees taken before it are paid whether the outcome is good or bad.

Two preferred returns at the same rate can behave differently

Cumulative or non-cumulative

A cumulative preferred carries an unpaid shortfall forward. A non-cumulative one does not: a year that pays nothing is a year that paid nothing, and the balance resets. Across a hold with lumpy cash flow, that one word decides more than the rate does. Our published summary of terms describes the preferred as an accrual. Whether it is cumulative, and whether it compounds, is set in the operating agreement, and that is the document to read.

Compounding or simple

A compounding preferred accrues on the unpaid balance as well as on the capital, so an unpaid year raises the base for the next one. A simple preferred accrues only on contributed capital. Where years pass before there is cash to distribute, the gap is not marginal.

What a band tied to commitment size means

Our preferred returns are published as bands rather than single figures: the rate rises with the commitment. The upper end is not the offering’s rate but the rate available to the largest commitments. Setting the top of a band against a bond’s yield compares the best case of one instrument with the contractual case of the other.

The bands for both funds are published in full, next to offering size, structure, targeted hold period, and liquidity, on the page that carries both funds’ terms. They live there because a figure belongs beside its qualifications. To see what a commitment at a rate inside a band looks like after tax, the after-tax calculator models it.

Interest in a debt fund is not a preferred in an equity fund

Capital participates in private real estate as a lender or as an owner, and both positions are set out on the investors page. Each can quote a similar-looking number and mean something different by it.

In a debt fund the money is lent to the projects and the return is the interest on those loans. That position sits ahead of the equity in the projects, and the return is capped at the rate. In an equity fund the money owns a share of the projects, and the preferred orders payment among the owners, who all stand behind every lender. A preferred return does not move an equity position up the capital stack. It orders the queue inside the equity, which is the last claim in the structure.

What a preferred return is not

• Not secured. It is a contractual ordering among partners, not a lien on the property.
• Not senior to the lenders. In an equity fund the preferred is senior only to other equity, and everything in the waterfall happens after debt service. A debt fund’s loans sit ahead of the project equity: the same word, a different position.
• Not a promise of payment. Whether it is paid depends on whether the cash exists.
• Not a rate to annualise casually. An accrual settled at a sale years out is not the same investment as the same rate paid quarterly from the start.
• Not a description of your tax position. A distribution is not the same thing as taxable income, and in a development deal the two can point in opposite directions for years, the subject of why new development produces paper losses.

What to ask, and where to look

Each is answered in the distribution section of the operating agreement, not in a summary of terms:

• Is the preferred cumulative, and does it compound?
• From what date does it accrue, on what amount, and per investor or pooled across the class?
• Where does it sit relative to return of capital, and is the ordering the same for sale proceeds?
• Is there a sponsor catch-up, and is it a full one?
• What happens to an accrued balance if the hold runs long, or if the asset is refinanced rather than sold?

A sponsor who cannot answer those from the document is not the right sponsor. The communities map shows the buildings the money goes into, and our investor relations team will take you through ours.

A preferred return is not a guarantee of payment. Distributions are not guaranteed, may be reduced or suspended, and investors may lose some or all of their capital. Development carries construction, lease-up, and refinancing risk, private real estate is illiquid, and past results do not predict future results. The fund documents govern.