A preferred return means that investors are the first to receive returns up to a pre-determined level. Upon reaching this level of return, the remaining profits are split according to the negotiated rate. The preferred return is also premised upon the full return of the original principal investment to the investor.
As an example, a REIT might offer an 8 percent preferred return with an 80/20 split above and beyond the 8 percent preferred return. Let’s assume that the investor initially contributes $100, and that the property’s cash flow has an average of 6 percent annually over the 5-year hold period. The REIT manager would need to distribute $140 to the investor over the course of the investment to achieve the preferred return. The $140 is broken down as $100 of principal plus $40 due to the 8 percent annual rate and the 5-year hold. It is determined at the time of the initial offering that $30 will be distributed over the hold period in the form of cash flow, which can be paid monthly or quarterly.
Assume that the investor’s interest in the property is sold for $130 after closing costs, the sponsor distributes to the investor the full original principal amount of $100 plus the remaining $10 to reach the preferred return total of $140. At this point the 80/20 profit split is applied to the remaining $20, with $16 being distributed to the investor, and $4 to the sponsor. Thus, in total the investor would invest $100 and receive a total of $156 on the back end for a non-compounded IRR of 11.2 percent. The REIT manager would receive $4 plus reimbursement for certain asset management costs or other fees. These numbers are only an illustration of the way a preferred return structure works at the disposition of the property and the close of the investment (refer to graphic below). All such investments entail significant risks which have been highlighted in the Risks section of our Learning Corner. It is possible for such investments to incur loss to principal, or a total loss of principal. Likewise, cash flow over the hold is not guaranteed.
REIT investments can be an attractive choice for investors seeking to reallocate into alternative real estate investments. REITs provide excellent diversification across properties, asset classes, and geographically, either within one REIT or by investing in multiple REITs. REIT investments provide both the benefits and risks of real estate investments, such as rent-based cash flow, depreciation, and appreciation potential. While market-traded REITs offer liquidity and often larger size, non-publicly traded REITs are non-market correlated, hedging against market volatility, though they do typically require a multi-year hold period with limited exit options during the hold. These non-traded REITs can be either private placement securities for accredited investors, or available to suitable investors who meet the 250 70/70 financial qualifications, thus providing an option to invest in non-publicly traded real estate securities to non-accredited investors.
The provided demonstration of REIT investment return above is a fictional representation and not based on a real investment return. its purpose is solely to serve as an illustrative example.