Preferred return

A preferred return, often shortened to pref, is a hurdle written into the agreement between a developer and its equity investors. Cash flow and sale proceeds go first to return the investors' capital and pay them an agreed annual rate on it. Only after that hurdle is met does the developer receive a disproportionate share of what remains, sometimes called a promote or carried interest.

The structure exists to align interests. Investors are protected from a developer who earns fees and profits while they lose money; the developer is rewarded for beating the hurdle. Assume investors contribute $8,400,000 with an 8% preferred return: they are entitled to $672,000 a year before the developer's share of profits begins, and if cash flow falls short in a given year, the shortfall usually accrues and must be caught up later.

The preferred return is not the same as the total return investors expect. It is a floor. The investors' full expectation includes a share of the profits above the hurdle, and is usually expressed as a target internal rate of return over the life of the investment.

For housing costs, the preferred return is one expression of the cost of equity, which is the most expensive money in a project. Because the pref must be paid before the developer earns its promote, a developer setting rents for a new building is doing so to clear the hurdle first, and the hurdle is set by what investors could earn elsewhere.