I was thinking about these calculations for awhile and trying to articulate the core underlying math. Here is my video and a good explanation of the implications of various types of rates that could be used in a joint venture preferred return waterfall model. This is relevant for model calculations that are happening on a monthly basis.
See examples of these calculations in both my real estate models and joint venture models (you can download the templates to learn more).
In many partnership or real‐estate syndication agreements, investors are promised a “preferred return” (sometimes also called a “pref”) before the sponsor or operator receives additional profit splits (the “promote”). There are two common ways that this preferred return can be structured:
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Simple Preferred Return Rate (e.g., an 8% annual preferred return)
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IRR Hurdle (e.g., an 8% IRR hurdle)
Both of these can be called a “preferred return,” but the mechanics behind them are quite different—especially when distributions are made on a monthly basis. Below is an in‐depth look at how each calculation works, and why monthly distributions become particularly relevant.
1. Simple Preferred Return Rate
How It Works
A simple preferred return rate is typically expressed as an annual percentage (e.g., 8% per year) on the unreturned capital balance. It means:
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Each investor is entitled to receive an 8% return (annualized) on their contributed (and not yet returned) capital before the sponsor receives any profit split above that.
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Once the investor has received their 8% preferred return for the period (plus a return of capital, if applicable), additional profits can be split according to the agreement (e.g., 70% to investors, 30% to sponsor, or whatever the waterfall dictates).
Monthly Relevance
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Pro Rata and Accrual: Since most real estate projects produce cash flows monthly (e.g., rental income), distributions may be made monthly (or quarterly). If your preferred return is set at 8% per year, you typically divide 8% by 12 for a monthly rate (≈0.6667% per month).
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Accrual vs. Distribution: Whether you actually pay out each month or accrue the pref is a matter of the project’s cash flow. In some deals, you send monthly checks to investors (if enough net cash flow is available). In other deals, the pref may accrue and be paid out at refinancing or sale.
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Simple vs. Compounding: Most simple preferred returns do not compound monthly (i.e., you just track 8% annual on the principal that’s still invested). If it does compound, then each month’s pref amount gets added to the unreturned capital, increasing the base on which the next month’s pref is calculated. Whether or not it compounds can be spelled out in the operating agreement.
Key Point
Timing of distributions does not directly change the “rate” of the pref in a simple preferred structure. You still owe that 8% per year (or its monthly equivalent). The monthly aspect is just a matter of (1) how frequently you pay it out and (2) how you split the partial months if capital is contributed or returned mid‐month.
2. IRR Hurdle (Preferred Return as an IRR) - I talk about this one first in the video.
How It Works
An IRR (Internal Rate of Return) hurdle means that the sponsor only starts earning the promote (the higher split of profits) after the investors achieve a target IRR—often stated as “8% IRR.” IRR is a time‐weighted calculation that considers when capital goes in and when distributions come out.
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Definition of IRR: Mathematically, IRR is the discount rate at which the net present value (NPV) of all cash flows (inflows and outflows) equals zero. The sooner investors get their capital back (and additional returns), the higher the IRR.
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Relevance to Waterfall: If the deal is structured so that there’s an 8% IRR hurdle, the sponsor must ensure that each investor’s cash flows over the life of the investment meet or exceed an annualized 8% IRR before the sponsor can “catch up” or move into a higher promote split.
Monthly Relevance
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IRR is Highly Sensitive to Timing: Because IRR specifically measures the annualized return based on the timing and amount of cash flows, paying distributions monthly vs. quarterly vs. annually makes a substantial difference to the investor’s IRR.
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For example, if you distribute $100,000 in monthly increments over a year, the IRR to the investor is higher than distributing the same $100,000 in one lump sum at the end of the year.
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Modeling Monthly Flows: In an IRR-based waterfall, you must track the actual cash flow dates. Many waterfall models will break down distributions by month, precisely because IRR changes depending on how early or late funds go back to investors.
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Hitting the IRR Hurdle Sooner: If you pay out cash flow monthly, an investor’s IRR will accelerate because they’re getting money back earlier. As soon as an investor’s IRR crosses the 8% threshold (looking back over all their cash inflows/outflows), the deal can shift into the next “tier” of the waterfall, allowing the sponsor to start earning the promote.
Key Point
With an IRR-based hurdle, the timing of distributions throughout the year (monthly vs. quarterly vs. annually) directly affects whether and when the IRR hurdle is met. This timing sensitivity does not exist in the same way under a simple preferred return rate, where the percentage is owed regardless of when it is paid.
Why This Is “Only Relevant” for Monthly (or Periodic) Distributions
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Cash Flow Timing: If a project paid only one distribution at the very end (e.g., at sale five years later), the difference between a simple annual pref and an IRR hurdle would exist, but there wouldn’t be intermediate distribution dates to worry about. The entire return calculation would hinge on just two data points per investor: the date capital was contributed and the date the final distribution was paid.
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Periodic Payments Affect IRR: In reality, many real estate deals generate positive cash flow monthly (from rents, for example) and often pay distributions monthly or quarterly. Once periodic distributions are introduced, time weighting becomes a major factor for IRR. Each of those “mini” cash returns can bump up the IRR, potentially helping the sponsor reach the hurdle faster.
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Accrual vs. Actual Payment for Simple Pref: For a simple pref, if a sponsor doesn’t pay monthly, that 8% (or whatever the annual rate is) would typically accrue. The point is that with or without monthly distributions, under a simple pref the rate stays the same—what changes is whether investors are receiving it incrementally (monthly/quarterly) or in a lump sum at a capital event. By contrast, under an IRR hurdle, receiving money sooner directly improves the calculated IRR, affecting the sponsor’s promote eligibility.
In Summary
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Simple Preferred Return Rate (e.g., 8% annual):
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You owe 8% per year on the unreturned capital—period.
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Monthly distributions might be how it’s paid out, but it doesn’t change the rate or the fact that you owe 8% for as long as the investor’s principal is outstanding.
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Timing of actual payments does not make the total return more or less than 8% (unless the deal specifies compounding).
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IRR Hurdle (e.g., 8% IRR):
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The hurdle is time‐weighted. Paying out each month vs. once a year dramatically changes the IRR.
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Once the cumulative IRR to investors hits 8%, the sponsor can move to the next tier of the waterfall (where the sponsor typically earns a “promote”).
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Distributing earlier means the investor’s IRR grows faster, which can reach the 8% threshold sooner.
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Because IRR is entirely about when you get your money back, monthly distributions matter much more in an IRR hurdle structure than in a simple preferred rate structure. That is why you see more detailed, period‐by‐period waterfall modeling (often monthly) in IRR deals, whereas with a simple preferred rate, you are often just tracking an annual 8% (or similar) without as much emphasis on the precise month‐by‐month returns.
Article found in Joint Venture.
