What is Preferred Return? In Relation To Real Estate in Israel

What is Preferred Return?

Preferred return, commonly referred to as a “pref,” is a financial concept used primarily in private equity and real estate investment deals. It provides investors with a specified rate of return on their invested capital before any profits are shared with the project’s sponsors or general partners. This return is often seen as a safeguard for investors, ensuring they receive a minimum return before profits are split.

In real estate, preferred return structures are common, where investors earn a priority on returns from profits generated by a development or property. These are usually expressed as a percentage and often calculated on an annual basis. For example, if an investor is promised an 8% preferred return, they will receive their portion of profits first until they achieve that 8% return on their investment, after which any remaining profits are divided according to the agreed-upon terms.

Preferred Return in Israeli Real Estate

The Israeli real estate market, like many others, has embraced preferred returns, especially within real estate investment funds. As property prices continue to rise in urban centers like Tel Aviv and Jerusalem, investment funds have increasingly structured deals to offer preferred returns to attract foreign and domestic capital. Investors, especially those from abroad, are often drawn to Israel due to its growing economy and high demand for housing, making preferred returns a useful tool in balancing the risks and rewards of such investments.

Israel has seen substantial foreign investment in its real estate market, particularly through large debt offerings. For example, US investors have raised significant funds by issuing real-estate bonds in Israel, appealing to both institutional and individual investors. The preferred return structure provides a form of risk mitigation, especially in a volatile market where property values are rising rapidly but with periodic corrections due to economic or political factors.

Impact on Real Estate Buyers and Investors

For buyers and investors, preferred returns can impact decision-making in several ways:

For Investors: Preferred returns offer a level of security, especially in large-scale real estate developments or funds where capital preservation is important. In markets like Israel, where property prices in high-demand areas such as Tel Aviv, Jerusalem, and Herzliya continue to rise, pref structures are particularly appealing to cautious investors looking for steady returns.
For Developers: Real estate developers in Israel, particularly those engaged in large projects, use preferred returns to attract significant equity investments. This helps them secure financing for development, especially in high-cost areas. In 2023, as interest rates increased, developers faced challenges securing financing, making preferred return arrangements an attractive solution to entice investors while managing debt burdens.
For Homebuyers: While preferred returns primarily affect investors, the larger market dynamics influenced by such structures can trickle down to homebuyers. For example, in times of low investor confidence, developers may need to offer better terms to investors, potentially affecting the supply and pricing of housing stock in key areas. Thus, homebuyers could face higher prices or fewer available properties in prime locations.

Data-Driven Insights and Market Trends

The Israeli real estate market, especially in key urban centers, has experienced substantial growth in recent years. According to recent reports, Israel’s housing market was characterized by both strong demand and rising property prices throughout 2023. However, with interest rates increasing, fewer buyers have been able to secure mortgages, which has led to a slight cooling in the market. Despite this, real estate remains a popular investment, with preferred return structures continuing to play a key role in attracting capital to major projects.

For instance, large institutional investors and high-net-worth individuals have been able to secure preferred returns of up to 10% in some funds, particularly those focused on high-growth areas like Tel Aviv. This guaranteed return provides confidence in the stability of Israeli real estate as an investment, even in times of economic uncertainty or geopolitical risks.

Actionable Advice for Investors and Buyers

For those considering real estate investments in Israel, it’s important to understand the role preferred returns play in structuring deals:

For Investors: Preferred returns can reduce the risk of real estate investment, especially in markets prone to fluctuations. If you are considering investing in Israeli real estate funds or large developments, seeking opportunities that offer a preferred return is a good way to ensure a minimum return on your capital.
For Homebuyers: Even though preferred returns are primarily an investor-focused tool, their presence in the market can indirectly affect housing prices and availability. Buyers should be mindful of overall market trends and consider the impact of investor activity on housing stock, particularly in high-demand cities like Tel Aviv and Jerusalem.
For Developers: As financing becomes more difficult to secure, offering preferred returns to investors can be an effective strategy to continue developing projects in competitive markets. Developers should structure their deals to remain attractive while also ensuring they can meet their financial obligations.

Global and Local Perspectives

Globally, preferred returns are a standard practice in real estate investment, offering a way to mitigate risk and attract capital. In Israel, this practice has gained traction, especially as foreign investors continue to view the country as a safe and profitable market. With the potential for increased immigration and high demand for housing, especially in urban areas, preferred returns will likely remain a significant part of the real estate landscape in Israel.

At the same time, local developers and investors must balance these opportunities with the challenges posed by rising interest rates and an evolving economic environment. For real estate players in Israel, understanding and utilizing preferred returns can help navigate these complexities while maintaining profitability.