Preferred Returns vs Cash-on-Cash Returns
# Preferred Return vs. Cash-on-Cash Return: What Every Investor Should Know
Lately, I’ve been getting a lot of questions about preferred returns and cash-on-cash returns—and how they differ.
Some investors mistakenly think that an 8% preferred return means they’ll be receiving 8% in annual cash distributions. Not quite.
Let’s walk through what each of these terms really means, how they work in real-world deals, and why understanding the difference could protect your bottom line.
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## What Is a Preferred Return?
A preferred return—often called a “pref”—is a structure that gives investors a priority return on their invested capital before the sponsor earns a share of the profits (also known as the “promote”).
Think of it as a hurdle. The sponsor doesn’t get rewarded until you’ve earned a certain minimum return—often 6–10% annually.
💡 Important: A preferred return is not a guaranteed cash payment. It’s a threshold—not a promise.
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## What Is Cash-on-Cash Return?
Cash-on-cash return measures the actual dollars you receive each year as a percentage of your investment.
For example:
* You invest $100,000.
* You receive $6,000 in distributions this year.
Your cash-on-cash return = *6%**
This number reflects real cash in your pocket, not paper projections.
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## Can a Deal Have an 8% Pref and Only Pay 6% Cash-on-Cash?
Absolutely—and this is more common than ever in today’s cash-strained environment.
The preferred return sets the benchmark, but actual cash flow distributions may fall short in some years. When that happens, the difference usually accrues and is paid later—often at the sale or refinance of the property.
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## The Power of Compounding Preferred Returns
Here’s where things get interesting: If the preferred return compounds, the unpaid amount from previous years earns interest at the same preferred rate.
In other words, you’re not just owed what you missed—you’re owed what it could have earned.
This “time value of money” concept helps protect investors in low-cash-flow deals and incentivizes sponsors to perform.
🏢 Example: Development deals that don’t cash flow for the first few years often use compounding preferred returns to fairly compensate investors for the wait.
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## What About IRR, Equity Multiples, and MIRR?
Most people use IRR (internal rate of return) to compare investment opportunities. But IRR assumes all interim cash flow is reinvested at the same rate—which isn’t always realistic.
Some investors prefer MIRR (modified IRR), which lets you input a more conservative reinvestment rate (like 8%). Still, IRR remains the industry standard due to its universal application.
👉 That’s why I always recommend looking at:
*Average and annual cash-on-cash**
*Equity multiple**
*Preferred return structure (compounding or not)**
*Return of capital rules**
The more complete the picture, the better your decisions.
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## Does the Sponsor Get Paid Before You?
This depends on how the deal is structured.
In institutional deals, the sponsor doesn’t start earning profits until investors receive:
1. Their full preferred return, and
2. 100% of their original capital back
✅ That’s the gold standard.
In many retail syndications, though, there’s something called a cash flow promote, which allows sponsors to earn promote on any cash flow above the preferred return—even if investors haven’t received their capital back.
⚠️ Watch out for this. It’s not always in your best interest.
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## The Bottom Line
Preferred return ≠ cash-on-cash return.
If you’re evaluating a commercial real estate investment, ask these questions:
What is the projected *cash-on-cash return** each year?
Is the preferred return *compounding**?
Does the sponsor earn promote *before** or after investor capital is returned?
What’s the expected *equity multiple** at exit?
These nuances can dramatically impact your overall returns.
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