The generally acceptable preferred return rate in a preferred equity real estate deal is typically higher than the risk-free rate of return, which is the return an investor can expect to earn from a completely risk-free investment such as a US Treasury bond.
The risk-free rate of return varies over time. Around the Fall of 2021 this rate was 1.5% to 2%. In contrast, the preferred return rate in a preferred equity real estate deal is typically higher, ranging from 6% to 10% or more, depending on the specific deal terms, risk profile of the investment, and market conditions.
The reason for this difference in return rates is that real estate investments, including preferred equity investments, involve inherent risks such as market fluctuations, changes in interest rates, and unexpected maintenance and repair costs. Investors demand a higher return to compensate them for these risks.
It's important to note that the preferred return rate is not directly comparable to the risk-free rate of return, as they represent different types of investments with different risk profiles. However, in general, a preferred return rate that is significantly higher than the risk-free rate of return is usually considered acceptable for a real estate investment with moderate to high levels of risk.
The preferred return in a preferred equity real estate deal can vary depending on the specific terms negotiated between the parties involved. However, generally speaking, the preferred return is a fixed percentage rate of return that is paid to the preferred equity investors before any distributions are made to the common equity investors.
The preferred return is often structured as an annual rate of return, typically ranging from 6% to 10%, but can go higher or lower depending on the deal. The rate of return is usually negotiated based on various factors such as the risk involved, the property's projected cash flow, and the overall market conditions.
It's important to note that the preferred return is only paid to the preferred equity investors if the property generates sufficient cash flow to cover the payment. If the property does not generate enough cash flow to cover the preferred return, the payment is deferred until the property's cash flow improves.
Overall, the preferred return is a key component of a preferred equity real estate deal that helps provide investors with a level of certainty and a fixed rate of return while also mitigating some of the risks involved with investing in real estate.
General Expected Returns of Various Types of Real Estate:
Keep in mind these are final returns and often times a preferred return will be accompanied with carried interest that gives an LP some participation to the upside, depending on the deal. In that case, final exit IRRs could be quite a bit higher than a single preferred return rate. Here are a few generalized rates you may expect for various real estate asset classes.
- Residential real estate: This would be single-family homes, condominiums, townhouses, and multi-family apartment buildings. Investors in residential real estate typically aim for a total return of 8% to 12% per year, which includes both rental income and appreciation of the property value over time.
- Commercial real estate: Includes retail properties, office buildings, industrial properties, and mixed-use properties. Investors in commercial real estate typically aim for a total return of 10% to 20% per year, which includes rental income, appreciation of the property value, and potential income from ancillary sources like parking fees, signage fees, and concessions.
- Real estate investment trusts (REITs): A REIT is a company that owns, operates, or finances income-generating real estate. Investors in REITs can expect a total return of around 8% to 12% per year, which includes both dividend income and appreciation of the share price.
- Real estate crowdfunding: Real estate crowdfunding platforms allow investors to invest in specific real estate projects alongside other investors. Investors in real estate crowdfunding can expect a total return of around 8% to 12% per year, which includes both rental income and appreciation of the property value over time.
Preferred Equity Could Come with Many Stipulations, here are a few more templates that have features of this kind of financing deal:
