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This episode is the second part of our series about operating agreements. Thomas Castelli and Kaylyn Deaver discuss the ins and outs of preferred returns. If you haven't listened to OA 01, you should check that out first!
Preferred returns are something we see in almost every operating agreement. There are multiple different types and they can be structured in different ways. A preferred return is essentially a preferential distribution of profit.
For example, a partnership could state that the first 10% of cash flow is to be distributed to the LPs, and the remainder is distributed according to a waterfall structure or by percentage interest in the partnership.
"The purpose of this type of return is to give investors a sense of security and that they're going to receive priority in the profits the fund generates."
Fixed Preferred Returns
The second type of preferred return, the one we're focusing on today, is a fixed return. It's calculated annually and it's based on investors' individual capital contribution.
These fixed preferred returns are typically in the 6%-10% range. There are many factors that can drive this, such as investor sophistication, fund goals, relationship to the investor, and location. Location plays a big role in this rate, as there may be larger gains expected on the back end due to appreciation.
Investors generally receive these payments once a year. These payments will always be made at some point, but the timing is often up to the discretion of the fund manager. These payments accrue. If the manager sees a potential cash flow problem with making these payments, he or she may opt to allow the payments to accrue. In some cases, the entire sum of all fixed preferred payments could be made at once upon the sale of property when the cash is freed up.
"Look through your operating agreement and make sure to ask for clarification if it's not stated directly."
Typically, a fixed preferred return is calculated based on the number of days.
Capital contribution: $100K
Length of time: 1 year
Fixed pref. rate: 8%
With these assumptions above, the investor can expect a payment of $8,000 in year 1. If not paid, it will accrue. $16,000 would be due in year 2.
However let's say, on Jan. 1 of year 2, the investor receives a distribution of capital of $25K. At this point, $75K is remaining in the deal.
If the OA says the payment is calculated based on the original capital contribution, the investor is still set to receive the $8,000 at the end of year 2. If we're using an OA based on unreturned capital, your pref. on year 2 would be $6,000 because it's 8% on $75K.
"Typically what we've seen, because a preferred return is generally based on your original capital contribution, it's mandatory to be paid each year or it accrues, and it's one of the first things paid out before even capital is returned, it generally should be classified as a guaranteed payment."
It's going to appear on your K-1 as income and will be subject to your ordinary tax rate. This is important is because most passive real estate investors can't use real estate losses to offset this income. We also see preferred returns treated as distributions, but it depends on the verbiage in the OA. Truthfully it's going to come down to the CPA and how the OA is interpreted.
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