“If you’re long-term oriented, customer interests and shareholder interests are aligned.” — Jeff Bezos
Are preferred returns better than a multifamily straight split or other investing deal?
I got this question from Larry in Texas.
Larry, thanks for asking this!
There’s a lot of people wondering about this as well.
He asked for a breakdown comparing deals with and without preferred return.
How does it work as a passive investor?
How do you get paid as a general partner?
Let’s jump in!
1. What Are Preferred Returns and Straight Splits?
What does a preferred return actually mean?
Is it really preferred?
A common preferred return deal structure is an 8% pref (short for “preferred return”) and then a 70/30 split of profits.
Let’s break down what that means.
If you invest $100,000, you’d expect about $8,000 per year in cash flow from that deal from the preferred return.
After that amount, there would be 70% to 30%.
You give 70% of any profits going forward above the 8% to the limited partner
It’s important to remember that preferred returns do not limit your returns.
It’s not like you only get the 8%.
The split is a baseline.
Investors get paid before the operator.
They get the first 8% and the operators don’t.
With a straight split, it goes straight 80/20 or even a straight 70/30.
There’s no preferred return.
Immediately from dollar one, the profits spread to both parties.
Preferred return doesn’t guarantee you’ll get paid that amount.
It could be less.
Thankfully, there’s usually a catch-up clause to help get you there with preferred return deals.
Let’s get into some examples to really compare the two structures.
2. Preferred Returns vs. Straight Split Examples
We’re going to pretend you’ve invested in a deal that raised $5 million with $100,000 in quarterly profits.
If you invest $100,000 in a preferred return deal, you are getting paid before the general partners.
For these examples, let’s say there’s an 8% pref.
100% goes to the limited partners until they get their 8% annual return.
If it’s an 80/20 split, then something else would happen.
$80,000 would go to the limited partners and $20,000 would go to the general partners.
Here’s something to note: General partners and operators typically put in about 5% to 10% of the total amount invested into deals.
At Bronson Equity, we’re both an LP and GP.
That’s one scenario.
Let’s tackle another one! There are some other assumptions here but I wanted you to get a feel for how it works.
Instead of having a $100,000 profit per quarter, you have a $200,000 profit per quarter.
First, let’s look at the preferred return.
In this case, we’re dealing with more money.
For the pref: $100,000 would go to investors plus $70,000 because that would be above the pref.
In total, you’d give $170,000 to limited investors and $30,000 to general investors.
What about the other option?
What would $200,000 profit in a quarter look like with an 80/20 split?
That option would give $160,000 to LPs and $40,000 to GPs.
It’s pretty close but a little different.
What happens if we change it again and have a profit blowout?
Let’s say we had $500,000 in quarter profits.
That’s usually a point when you consider refinancing or selling.
But we’re going to instead apply the same model we’ve been using.
With a preferred return, $380,000 goes to LPs and $120,000 goes to GPs.
With an 80/20 split, those numbers change.
You would give $400,000 to LPs.
More money goes in this situation if you had a straight split rather than if you had a pref.
Prefs are not always preferred.
This is where LPs start making more money.
It really kicks in at the sale.
At the end of a deal, let’s say you’ve got $5 million in profits from the sale.
How will you split this between the passive and general partners?
With a pref, we have a 70/30 split because investors have been getting their prefs.
$3.5 million goes to the LPs and $1.5 million to the GPs.
With an 80/20 split, $4 million goes to LPs and $1 million to GPs.
If there’s a lot of profits, the straight split is actually a better model for the limited partner.
But now come the questions of when you get paid.
Do you get paid first?
How does that work?
For this reason and many more, we need to figure out which method is better.
3. Which is Better?
Is a preferred return or straight split better?
I prefer to have a straight split.
In other words, I prefer not to have a preferred return.
When you have a straight split, you’re aligned with your interests.
We typically invest 5% to 10% of the total amount invested alongside our investors.
There was a recent study of large Wall Street fund managers that showed less than 50% had a single dollar invested in the fund they were managing.
That’s a misalignment of interest.
The closer you can align interest, the better.
We do deals both ways.
I’m not saying one is right or wrong.
Preferred returns can sound great as an investor.
Investors may be used to preferred returns.
A lot of institutions are structured that way.
If you have a straight split from dollar one, it might hurt investment returns where it goes down a little bit.
But it really helps the general partners.
I don’t think it’s necessarily a good idea to starve a general partner so I can get paid before them.
General partners set the structure of how this works.
The closer you can align your interests, the better it is for both parties.
Each situation is different and you have to form your own opinion.
Now I want to hear from you!
Are you a preferred return person?
Do you prefer straight splits?
Let us know in the comments.
Before you leave, make sure to check out our special report about inflation investing. It shares the best choices to invest during an inflationary environment.
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Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.