In private real estate investing, a preferred return is the minimal rate of return an investor must obtain before an investment manager may earn a performance fee. In real estate investing, the recommended return is often between 6 and 9 percent, depending on the risk of the venture. You may think of this as an interest payment on your money since it accrues similarly, but this payment is not guaranteed.
Performance fees connect the real estate manager’s interests with the investors. Guaranteed costs such as yearly asset management fees pay for real estate managers’ wages and keep the lights on, but the performance fee, often the most significant portion of their remuneration, incentivize the manager to generate outsized profits for investors.
As a result, real estate managers are driven to be efficient with cash and return capital so that they may begin sharing in the upside as soon as feasible. Prudent real estate management will not start a project if they do not feel they can substantially beat the target return.
How a Capital Account Balance Is Necessary to Comprehend the Preferred Return
The wish to return on a real estate investment cannot be understood without a capital account. A capital account is an individual account for each person’s investment funds as they accumulate towards the total investment. A capital account enables these folks to comprehend their holdings and the growth of their investment over time.
Typically, the capital account maintenance is handled by the investment’s administrator or an external accounting firm, and account details are not disclosed on investor statements. The capital account balance declines as capital are repaid, but it climbs as the preferred return accrues. A capital account balance is computed by multiplying the unreturned capital balance by the select return prorated for a specific period.
For example, assume that $500,000 was invested on January 1 and that the desired rate of return is 8%. On June 30 of that year, the capital account balance will be $520,000. This is not what the management owes but rather the amount the manager would be required to pay the investor before collecting a performance fee. In a typical real estate investment waterfall (a technique that describes how cash distributions are split between the management and the investor), the preferred return is paid first, followed by the return of the investor’s capital. Afterward, the administration will get a disproportionate percentage of the earnings since they exceeded the desired return.
How Fair Market Value is Relevant
Many investors mistakenly assume that the preferred return is a distribution that affects their fair market value. As indicated on investment statements, the fair market value of an investment is the value of your proportionate ownership in the assets the following liquidation.
As dividends are given, the fair market value declines, but it rises as the value of your investment grows. The fair market value of the investment may exceed or fall short of the capital account value. Extending the preceding scenario, the investment’s fair market value might be $550,000, meaning the management would receive a performance fee if the asset were liquidated today. On the other hand, the fund may have a fair market value of $500,000, indicating that the minimal criterion is not met, and the management would not get a performance fee if the fund were liquidated.
| Date | Capital Account | Fair Market Value | Performance Fee Earned? |
| Jan-1 | $500,000 | $500,000 | No |
| Mar-31 | $510,000 | $500,000 | No |
| Jun-31 | $520,000 | $550,000 | Yes |
Preferred Return in Implementation
It is essential to realize that the preferred return accumulates even when investors get partial payments. If the management makes a payment of $250,000 on June 30, assuming the same capital account level of $520,000, the unreturned capital amount will be $270,000. Unless otherwise, on the condition that in the operating agreement, the distribution, or investor payment, is first used to pay down the $20,000 preferred return, and the remaining $230,000 is used to pay down the $500,000 unreturned capital balance. The new unreturned capital balance is $270,000; from then on, the preferred return will accrue on this amount.
| Date | Capital Account | Fair Market Value | Distributions | Performance Fee Earned? |
| Jan-1 | $500,000 | $500,000 | $0 | No |
| Mar-31 | $510,000 | $500,000 | $0 | No |
| Jun-31 | $520,000 | $550,000 | $250,000 | Yes |
| Jul-1 | $270,000 | |||
| Tiers | ||
| Preferred Return | $20,000 | |
| Return of Capital | $230,000 | |
| Profit Split | $0 |
Alternatively, if the manager sells the asset on June 30 and returns $600,000, both the preferred return and the unreturned capital balance would be fulfilled, and the manager will be entitled to 10 to 30 percent of the $80,000 gain over the desired return.
| Date | Capital Account | Fair Market Value | Distributions | Performance Fee Earned? |
| Jan-1 | $500,000 | $500,000 | $0 | No |
| Mar-31 | $510,000 | $500,000 | $0 | No |
| Jun-31 | $520,000 | $700,000 | $600,000 | Yes |
| Jul-1 | – | |||
| Tiers | ||
| Preferred Return | $20,000 | |
| Return of Capital | $500,000 | |
| Profit Split | $80,000 |
It is conceivable that an investment is being liquidated, resulting in a positive capital account balance. Continuing with the previous scenario, suppose the $500,000 investment is sold for $400,000 on June 30. This money would first be utilized to pay the desired return of $20,000, then reduce the unreturned capital balance of $500,000. However, the remaining capital of $380,000 is insufficient to cover the entire unreturned capital balance, leaving the investor with a balance of $120,000. This is not a debt the management owes since the investment has been totally liquidated, and this sum will be deducted from the investor’s tax return.
| Date | Capital Account | Fair Market Value | Distributions | Performance Fee Earned? |
| Jan-1 | $500,000 | $500,000 | $0 | No |
| Mar-31 | $510,000 | $500,000 | $0 | No |
| Jun-31 | $520,000 | $400,000 | $400,000 | No |
| Jul-1 | $120,000 | |||
| Tiers | ||
| Preferred Return | $20,000 | |
| Return of Capital | $80,000 | |
| Profit Split | $0 |
In conclusion, the preferred return is only a rate of return tier that specifies multiple profit distributions. When a fund manager’s capital account balance hits zero, they often begin to participate in profits. Even though the desired return is not guaranteed, performance-based fees connect the manager’s interests with those of the investor.
On the other hand, an investment’s fair market value, which measures increases or losses in the investment’s worth, has nothing to do with the anticipated return. Investors should have a general grasp of capital account accounting, but fair market value accounting is significantly more important for determining the value of an investment so that growth can be followed over time.
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