A preferred return — often called a 'pref' — is a hurdle rate that limited partners must receive on their invested capital before the general partner earns any share of the profits. Common pref rates range from 6% to 10% annually, depending on the strategy and risk profile. The pref is not a guarantee; LPs only receive it if the property generates sufficient cash flow or sale proceeds.
The economic purpose of the preferred return is alignment. By forcing the GP to deliver baseline performance before earning promote, the structure ensures that the sponsor's incentive compensation is genuinely incentive-based, not a reward for raising capital alone. A 6% preferred with a 20% promote means the LPs get every dollar of return up to a 6% IRR before the GP starts earning extra.
How the pref accrues matters as much as its size. A 'cumulative' preferred return rolls forward unpaid amounts year over year — if year one only returns 4%, the missed 2% gets added to the year two requirement. A 'non-cumulative' pref resets each year, which is much more favorable to the GP. In practice, almost every institutional waterfall uses cumulative preferred returns, often with annual compounding.
Preferred returns interact with the catch-up provision and the clawback in ways that can dramatically reshape distributions. A pref with a full catch-up means once the LPs hit their hurdle, the GP receives 100% of the next dollars until the GP has 'caught up' to its target promote share. Understanding how these mechanics combine is essential to evaluating any CRE waterfall — and to negotiating one as either party.
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