I had an interesting conversation with an investor recently that highlighted a common misunderstanding in real estate syndications.
We were discussing Big Spring Capital’s typical deal structure for apartment buildings, and this investor kept asking questions about the preferred return (or "pref" as the cool kids call it). With each question, it became increasingly clear he had some fundamental misconceptions about how prefs actually work.
And honestly? I get it. Preferred returns seem straightforward on the surface, but there's a lot more complexity lurking underneath.
What A Preferred Return Really Is (And Isn’t)
At its core, a preferred return is simply a priority claim on cash flows.
Think of it like water filling up a series of buckets. Each bucket needs to fill up completely before water can spill over into the next one.
The pref represents one of the first buckets in what’s called the "waterfall" – the structure that determines how profits flow to passive investors and sponsors.
Here's a (simplified) breakdown of how it typically works on an apartment deal:
Operating income first covers property expenses, debt service, and fees
Remaining cash spills into the "bucket" for basic operating reserves
Next comes the preferred return bucket for investors
The LPs and GPs split the remaining cash
But here's the critical part: if there isn't enough water (cash flow) to fill the pref bucket, it simply doesn't get filled.
And that leads to the most important thing to understand about prefs:
A preferred return is NOT a guarantee.
That's why I cringe when I hear investors say "This deal has a 6% pref, so I'm guaranteed at least 6% returns."
Not true. Not even close.
Cumulative vs. Non-Cumulative
One of the most important distinctions in preferred returns is whether they're cumulative or non-cumulative. The difference can have a massive impact on investor returns.
Let's break this down with an example $100,000 investment in a deal with a 6% pref:
With a non-cumulative pref, it's like "use it or lose it":
Each year starts fresh
You're only entitled to the current year's pref
If the deal can't pay the full current year pref, that unpaid amount disappears
With a cumulative pref, unpaid preferred returns stack up:
Year 1: No distributions = $6,000 owed to you
Year 2: Still nothing = Now $12,000 owed
Year 3: Tab keeps growing = $18,000
The Good and Bad of Prefs
Prefs can be extremely valuable in the right situation. For example, in debt or credit funds, they provide a clear priority of returns that mirrors the underlying investment strategy.
But prefs aren’t without their challenges. Prefs can actually create misaligned incentives in certain situations.
If a deal falls behind and accumulates years of unpaid preferred returns, sponsors often lose motivation – after all, why work hard on a deal where you won't make money until a massive backlog of prefs is paid out (if it ever fully is)?
This is why at Big Spring Capital, we often prefer a straight equity split (85/15 LP/GP, for example) for our apartment deals. It keeps everyone rowing in the same direction.
The Bottom Line
Just because two deals both advertise a 6% pref doesn't mean they'll produce the same returns. The devil's in the details of the waterfall structure.
Before investing, take time to really understand how the pref works in a specific deal.
While prefs can provide valuable protection in certain situations, remember that the best returns often come from deals where sponsor and investor interests are perfectly aligned from day one.
And sometimes that means a more simple structure over a seemingly more protective one.