Imagine with me:
Two deals on your desk. Same property type, same market, similar projected total returns.
Deal A offers a 10% preferred return. Deal B offers a 7% pref.
Most investors pick Deal A without hesitating. A higher pref always means better investor protection and alignment, right?
Not exactly. That higher number might actually be a warning sign – and understanding why could save you from the exact scenario the pref was supposed to prevent.
A higher pref doesn’t create more cash flow
I’ve covered preferred returns before, but this misconception keeps surfacing in investor conversations: the idea that a higher pref automatically means a better deal for the LP.
If you take away nothing else today, just remember: a preferred return governs the order of who gets paid first. It doesn’t determine how much cash the deal ultimately produces.
A property generates whatever it generates – a 10% pref doesn’t magically create 3% more cash flow than a 7% pref. It just prioritizes more of your return earlier in the waterfall. Total returns are still driven by the underlying operations and the exit.
If our two example properties produce identical cash flow and sell for the same price, investors in both deals end up with roughly the same total return. The pref only changed the timing of distributions along the way.
So why would a GP offer a 10% pref?
If the pref doesn’t materially improve investor economics, an above-market pref is primarily a capital-raising tool.
A sponsor might set a high pref because they're competing for investor dollars in a crowded market. Or compensating for a thinner track record.
More insidiously, they could be using the headline number to draw attention away from less favorable terms elsewhere: higher fees, aggressive underwriting assumptions, or a speculative business plan that needs everything to break just right.
None of these are deal-killers on their own. But a pref well above market should prompt questions, not excitement. The first question I’d ask: what is this pref compensating for?
The incentive trap
When a sponsor sets a high preferred return and the deal underperforms, even modestly, they can fall so far behind the hurdle that they’ll never realistically earn their promote (the GP’s share of profits above the pref).
Now picture a sponsor managing multiple projects. One deal has a modest pref where the sponsor is earning their promote. The other has a 10% pref with two years of unpaid accruals stacking up.
Which deal gets their best resources and attention?
A sponsor staring at a growing pile of accrued preferred returns they may never clear (i.e., they will never make any money from the deal) has almost no financial incentive to fight for that deal’s turnaround. They’ll most likely redirect energy to the deals where effort still translates into compensation.
So the mechanism that was supposed to protect you (”you get paid before we do!”) ends up working against you. The sponsor disengages from the one deal where you need them most engaged.
The investors who chased the highest pref for maximum “protection” often end up with the least aligned sponsor at the exact moment alignment matters most.
What actually matters when comparing deals
A pref is one term in a much larger economic picture.
Before you compare prefs across deals, look at how the full structure fits together:
Fee structure: A 10% pref paired with excessive asset management and acquisition fees looks very different from a 7% pref with lower fees
Underwriting realism: If the deal needs 95% occupancy and 5% annual rent growth to support a 10% cash-on-cash return, that pref exists mostly in the GP’s imagination
Sponsor co-investment: If the GP has meaningful capital alongside yours, missing the pref hurts them too – this is true alignment
The preferred return is a structural term with real tradeoffs. The most important question is how it affects the sponsor’s incentive to perform over the full life of the deal – not just when things are going well, but when they aren’t too.
So when someone offers you a pref that sounds too good, ask what it’s really buying you, and what it might be costing in the alignment you actually need.