Passive investors: Why You Should Only Invest in a Preferred Return Investment

Passive Investors: Reasons to stay Passive vs. Active

Surprisingly, you don’t have to be an expert in real estate to invest in properties. Many passive investors - those who invest their money with sponsors - don’t participate in any of the day-to-day decisions regarding their investments. They are “limited partners,” while the person putting the real estate deal together is called the “general partner” or “lead investor/sponsor”. A passive real estate investor doesn’t have to deal with managing the asset or with any of the stress of the investment, as they’re not actively involved, and they have different ways of investing in real estate deals. 

It’s the same with locating the properties to invest in; the general partner is the one who has the knowledge and expertise to find the property with the most potential for profitability and present it to the passive investors. The sponsor, or general partner, is also the one who does all the hard work - from finding the property to doing due diligence on the investment to determining the best way to reposition or renovate it in order to maximize its profit potential.

Active investors have to dedicate their time and energy to the property. One of the biggest reasons to determine whether to stay a passive investor rather than an active one is to decide just how much your time is worth and measure that against the time you’d be spending on finding and managing the investment. The active investor is the one who gets the phone calls from the property management company regarding operational issues, such as problems with HVAC or mechanical systems. Those types of problems are going to take time and energy out of their day, and most investors aren’t interested in getting that intimately involved in the deal. 

Preferred Return Investment: First in Line to Receive Profits

Passive investors should only consider a real estate deal if they’re participating in a preferred return investment. A preferred return investment, or “pref” for short, simply means that any profits in a real estate project are first given to preferred investors. These preferred investors get to be the first in line to receive returns (from the income of the property, mainly rent), usually up to a prescribed percentage, which is generally 6 to 8 percent. After that percentage is reached, any additional profits are distributed to the sponsor, if there are any additional profits. This is the most commonly used return in real estate investments.

There’s no question that a preferred return is an important component of a real estate investment, as well as being extremely important to the interests of both the sponsors and the passive investors. If the fees don’t exceed the preferred return, the sponsor won’t receive those fees for managing the property. That’s why you should always look for a preferred return. Otherwise, the sponsor will still be compensated for managing the property even if the returns for passive investors are low. 

There’s another aspect of preferred returns, and that’s so the sponsor can show other investors that he or she can not only reach - but also exceed the percentage return that was initially promised. This works to instill confidence in the passive investors and provides a track record for recruiting other investors on future deals. 

Calculating Preferred Returns: Questions to Ask 

When it comes to preferred returns, there’s no template or pre-defined method used to calculate them. Each deal is separate and is structured by the sponsor. As a passive investor, there are some questions to ask regarding the way the preferred returns are calculated. 

First, find out of the return is compounded or non-compounded. A compounded return is one where the calculation of a preferred return's term growth comes from the amount of invested capital plus all amounts that were already earned but not yet paid. A non-compounded return is one where only the amount of invested capital is considered.

Other key terms to look at are a cumulative and non-cumulative return. A cumulative return indicates that any monies earned but aren’t paid out at the end of one period are carried forward into the next period. Non-cumulative returns are not carried over.

Also, on compounded preferred returns know the compounding frequency - is it monthly, quarterly, annually or continuous? 

All of these calculations and terms should be defined in the owner’s agreement before the deal is signed. There are simply too many variables it’s extremely important to put in writing the details of deal and how profits will be divided among the investors.  

Terms to Know: Different Types of Preferred Returns

There are different types of preferred equity and investors should become familiar with them prior to agreeing to any investment. 

• True vs. Pari Passu Preferred Return: “Pari Passu” is a Latin term that means equal footing. It means that an investor in a common equity position can still get a preferred return. This return is based on the treatment of sponsor capital, which is also known as the co-investment.

If the investor gets a preferred return before the sponsor, then the preferred return is called a True Return. When the sponsor and the investor receive the same preferred return at the same time, then it’s called a Pari-Passu preferred return.

So what’s the difference? With a True Preferred Return, the investor gets preferential treatment on the capital contribution. With the Pari-Passu Return, the investor doesn’t.

Simple Preferred Return vs. Cumulative

Preferred returns are not always calculated the same way. The sponsor can set up the preferred return on a simple interest basis, or on a compounding one. 

For example, if the investor is due a 10% annual preferred return, but there’s only enough profit to pay a 5% return after the first year, the difference will be added on in the second year to make up for the money they didn’t receive.

If they were using a simple interest basis, that additional 5% would be owed in year two, but it wouldn’t be added to the initial balance. If they were using a compounding basis, that 5% would be added to the investor’s capital account and used to calculate the preferred return for the next year.

Lookback Provision vs. Catch-up Provision

The difference between these two terms is important to note. With the lookback provision the sponsor and investor will “look back” and if the investor doesn’t receive his or her pre-determined rate of return, the sponsor will give up a portion of the profits that have already been distributed in order to give the investor their agreed upon rate of return.

In the catch-up provision, the investor gets 100% of all of the distributions of profit until a pre-determined amount has been achieved. After the investor gets their rate of return, 100% of the profits will go to the sponsor until the sponsor catches up with the amount paid. 

They’re similar, but in the lookback provision the investor has to ask for their money at the end of the deal, instead of getting it all up front with the catch-up provision. This is also all spelled out in the owner’s agreement.

While some of the terms sound confusing, they’re well thought out and important to understand, because as a passive investor you want to be able to maximize the money you’re investing in the preferred return deal. 

Summary

Passive investors should always look to participate in a preferred return investment for all the reasons outlined above. You want to be sure to be paid before others are paid in order to secure your real estate investment, and a preferred return investment will help you achieve that goal.