Evaluating an Investment – Value Add

A preferred return is an important metric to evaluate and look at and understand when you are evaluating a potential multifamily investment offering. Preferred rate of return simply means that the sponsor, the person putting together the deal, is saying, “Investors get paid this before I get paid.” We typically underwrite on our projects a 7 or 8% preferred return, meaning that of all the profit in the deal, there’s a minimum that needs to get met for investors first before management gets paid. There are folks that will argue for a preferred return, and there are folks that will argue against it. Here’s the thing that I have seen in my experience why people prefer one or the other. It’s what they’ve always done. If they’ve never done a preferred return, it’s probably because their mentor or somebody taught them when they’re starting out to do it that way, and so they’ve grown their career and do it that way. People that do offer a preferred return, their mentor or somebody that started with them probably went that way, and that’s just my experiences. People either like a preferred return or don’t because that’s how they started. It’s what you’re comfortable with, and that’s fine. There’s really no right or wrong way. We like a preferred return. It puts more pressure I think on the sponsor to deliver because they don’t get paid until after the investors have been satisfied, at least at some minimal level, 7 or 8% return. We want our projects to do much better than that, but we’re saying, “Hey, of all the cash flow, at least we’re paying the investors that first, then we get paid after,” and I believe it incentivizes the sponsor to make the project perform. Other people might argue that the preferred return is an undue burden on the project or it forces the sponsor to make short-term quarterly decisions. That’s a valid point. As a passive investor, I like a preferred return. I like getting those quarterly returns before the management on the project gets paid, but it’s something you want to look at to see, does the deal have a preferred return, and what are the terms if it does? We like them. Other people don’t. There’s no right or wrong way, but preferred return is something you want to understand as you consider investing in a multifamily project.