How can you promise a PREFERRED RETURN?

One of the comments I got was that if there is a guaranteed return, this investment must be too good to be true.

While most understand the difference, I thought it warrants a new blog entry.

What is a PREFERRED RETURN and how is it different from a GUARANTEED RETURN (which we most definitely cannot, do not, and will never promise)?

With a Prefered Return, the sponsor is promising not to dip into the profits before satisfying the preferred return to the investors.

While we will deduct certain fees and some out-of-pocket operational expenses, these are expected to be minimal, allowing us to successfully manage and operate the fund, and we will be fully transparent about any such expenses.

The remaining (and expectedly the) majority of the revenue will be distributed on regular basis to the investors, while the sponsors will remain 2nd in line, and will receive a fraction of the revenue only after the preferred return has been satisfied on a cumulative basis.

Let’s look at an example:

John invested $25,000 in the fund and expects a preferred return of 8% or $2,000 a year.

Proportionate to his share, the fund received in year-one only $1,700 in revenue. After deducting $125 in fees and $75 in expenses, leaving John with a net distribution of $1,500.

Since his preferred return has not been met, the difference of $500 is carried over to year-two.

If in year two John receives at least $2,500 in distributions his preferred return has been met for the first two years, and any additional revenue would be split 80% to John and 20% to the Operators. If the preferred return has not been met, the difference, again, is carried forward to the following year – and so on.

If over the life of the investment until the liquidation event (sale or refi), expected around the 5th year, the preferred return has not been met, the proceeds from the liquidation will be distributed in the following order:

  1. First, any preferred returns still owed, to meet the annual prefered return times the number of years the investment was held to this point.
  2. Secund, Return of the Capital Investment (in this example, $25,000)
  3. Third, a split between the Investor (receiving the lion-share) and the Operator until the Investor receives the target IRR
  4. and finally, a reverse split on any access revenue.

Note that the fund cannot, and does not promise that at any point the revenue will be sufficient to cover the expenses and the fees, or that there will be any funds left to distribute. Any investment in real estate, and this is no exception, has inherited risks. The above is just a general example and does not represent the terms of any specific fund investment. Please review the Offering Memorandum and Private Placement Memorandum for the full terms and conditions. Please consult with legal, financial, and tax professionals before making any investment decisions.