📈Simply Explained: The IRR Preferred Return

The term preferred return gets thrown around a lot. In reality, there are many different ways to structure a preferred return.

An IRR (Internal Rate of Return) preferred return hurdle is most commonly used in institutional real estate and private equity investments. But there are a few nuances that underwriters need to understand with this.

What needs to happen for limited partners to receive an IRR based preferred return? When do the general partners participate in the profits?

Let's demystify the IRR preferred return in a real estate transaction...

What is a preferred return?

In real estate syndication or partnership structures, the preferred return is typically agreed upon between the limited partners and general partner. The preferred return acts as a threshold or minimum rate of return that the investors must receive before the sponsor can receive a share of the profits.

The preferred return itself has nothing to do with the actual returns of the deal. Rather it's how the cash flow or profits are distributed.

Basically, the sponsor is promising the limited partners that they will receive a certain percentage return on their contributed capital, before the profits are split with the general partners.

The IRR Preferred Return:

An IRR preferred return hurdle in a real estate equity waterfall is a minimum internal rate of return that limited partners must achieve before a disproportionate share of the excess cash flow (i.e. the promote or carried interest) can be paid to the sponsor/GP.

The IRR preferred return structure is most commonly used in the institutional real estate space.

⚠️Important: If you remember anything from today's issue, let it be this! It’s impossible to hit an IRR hurdle without returning 100% of contributed capital.

Let's break this down...

Example 1: No Return of Capital

"It’s impossible to hit an IRR hurdle without returning 100% of contributed capital."

This investor contributed $100K and received some distributions every year. Let's say we want to offer a 6% IRR preferred return hurdle.

❌ Notice in the example above, this investor has not yet earned a 6% IRR. This is because they have not received their initial investment back.

The preferred return hurdle has not been met. The sponsors will not be paid since the limited partners have not received their promised preferred return.

Example 2: Return of Capital

Same scenario. But let's say there is a sale in Year 3 and this investor received some profit from the sale.

✅ In the example above, once the investor receives their initial capital back ($100K), they were now able to earn a 6% IRR.

The preferred return hurdle (6% IRR) has now been achieved.

The general partners can now share in the remaining profits and earn their promote. But this was only possible after the investor received their promised preferred return.

In most cases, the project will only be able to fully return investor capital at a capital event, i.e. a refinance or sale.

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What does that mean for the general partners?

The general partners will not share in the profits until a refi or sale since 100% of the distributable cash flow will be going to limited partners until that preferred return is met.

The general partners could go 5 years without getting paid! Make sure you understand that concept if you are a general partner and are structuring your deal with an IRR preferred return hurdle. 

If you are a passive investor, be sure to clarify exactly what kind of preferred return structure the sponsor is offering. Ask if 100% of the distributions are going to the limited partners until the preferred return is met.

And of course, don't hesitate to contact me with any questions!

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