One of the beautiful things about investing passively in a syndication is that without any heavy lifting on the part of the limited partner (i.e. the passive investor), there can be distributions (i.e. regular income) paid out over the lifecycle of a deal.
Sounds too good to be true, right? It’s not, however it’s important to learn what it means to either receive those cash distributions or how they will be accrued over time.
Cash Distributions vs Accrued Income
Let’s start with the basics. A cash distribution is money that is paid out on a monthly or quarterly basis that is part or all of the preferred return on your invested money. This cash distribution is a direct result of actual cash flow at the asset (i.e. rent collected).
Accrued income is any portion of the preferred return that isn’t paid out on the monthly or quarterly basis and is instead accrued over time.
Example Distribution Scenario: Year 1
For example, let’s say you’ve invested $100k at a 7% preferred return based on the projected proforma. In the first year of owning the asset the realized cash flow at the property allowed a 3% preferred return to be paid out. The limited partners (you, the passive investor) would receive the 3% preferred return paid out as a cash distribution directly into their pockets.
The remaining 4% of the preferred return will be accrued and will be paid out at a later time, when either cash flow at the asset allows for it or a capital event (i.e. sale of the property) happens.
Year 2 – 5
Now let’s say you get to the end of the first year and you’ve been paid $3k and you’ve accrued $4k. Now, moving into Year 2, there are no distributions paid out that year for various reasons – like a natural disaster struck the asset or the management team is building up reserves to be more resilient for an upcoming uncertain economy.
You’ve now accrued $7k (year 2 accrual) on top of the $4k that you already had accrued from the year before. This puts you at $11k of accrued income with $3k of cash distributions in the first two years. This pattern would continue through the lifecycle of the deal, until a capital event (for example the sale of the property) would then pay out that full accrued amount.
Year 5: Asset Sale
On the sale of the asset, whatever amount is in your accrual account gets paid first. Then everybody gets their original capital back. Then the profits are paid out according to the split between the LP and the ownership group.
Cash Reserves and Asset Cash Flow
When we’re raising funds here at Goodegg we don’t raise more than we need to put aside in a reserve account. We raise the amount required to purchase the deal and an amount for the necessary capex and reserves. What that means is that we’re paying out cash distributions from the direct cash flow of the property.
When we’re doing a value add component on any asset that we buy, the cash flow has the potential to grow over time. This equates to potentially having distributions lower in the first year or so of owning the property, but then over years 3, 4 or 5 that cash flow amount will grow as the expenses lower.
This would then allow the preferred amount to potentially be paid out in full over those years as well as have the accrued income be paid out. However there is always a possibility that the preferred return will accrue over the entire lifecycle of a deal and only be paid out at a capital event.
We focus on having cash reserves on the fund level and on each of the assets themselves. It’s not uncommon for us to have large amounts of cash reserves. As interest rates go up, if we don’t have the reserves to pull from, if need be, then there’s a potential for trouble. That’s why the cash reserves are so important.
What Does Preferred Return Mean?
The preferred return is the return that the limited partner will receive on their invested capital for the period of time that their money is held. Sounds simple right? It can get a bit confusing though as some mistake this as meaning cash distributions.
With a preferred return of 7%, it means that over the lifecycle of the hold period of that deal, you can make that percentage. If you’ve invested $100k at a 7% preferred return, you would receive 7% each year that the asset is held.
It’s important to note that when we get to the point where there is money to split with the general partners, the limited partners will get their return first and then the general partner will be paid out. That’s why it’s called a preferred return.
$100k investment + 7% preferred return + 5 year hold period = $35k on your investment
The preferred return is different from cash distribution. Cash distributions are based on the actual cash flow of the asset itself, at that present moment in time. If there’s enough cash flow at that time, the full preferred return amount would be paid out. If there isn’t presently enough cash flow, it would then be a percentage of the preferred return and the remaining amount would accrue over time.
Cash On Cash Returns and Why It Matters To Know The Difference From Preferred Return
Cash-on-cash return, sometimes referred to as the cash yield on a property investment, measures the investment performance and provides investors with an easy-to-understand analysis of the business plan for a property and the potential cash distributions over the life of the investment. This is different from the preferred return as that is measuring the return over the lifecycle of the deal. Whereas the cash on cash return is measuring cash in the investors pocket throughout the lifecycle of the deal.
If a deal comes across your radar that has a 6% CoC (Cash on Cash return) over the hold time, that means on average on an annual basis you’ll see that percentage in your pocket.
Let’s do math again. On a $100k investment, if a deal is projecting that on average you’ll have a Cash on Cash of 6%, it means over the 5 year hold period, you’ll have that money paid out to you in cash distributions. Then the preferred return is the money that you’ll get back on your original investment when there’s a capital event.
Monthly vs Quarterly Distributions
The common misconception is that the cash distributions will be paid out every quarter, however those are only based on the true cash flow of the property, after all operating expenses are paid out.
We typically focus on quarterly distributions here at Goodegg Investments. Previously there was a period of time that monthly distributions were happening. There are a few investment asset classes that will still pay out distributions on a monthly basis. However, moving forward, quarterly distributions make more sense from a cash flow perspective.
Quarterly distributions help mitigate cash flow and ensure that we have the potential to pay out as close to the preferred return as possible. That is still not ever guaranteed though and even with quarterly distributions, any return not paid out will be accruing.
It’s important to balance any investments you have with the knowledge of whether they are monthly or quarterly distributions and what the projected CoC return is. Investors can then make financial projections and decisions based on their specific portfolios.
Distribution Expectations After Closing
The deal has closed and it’s an exciting time! One of the first questions asked is usually along the lines of, “Can I expect to see my entire 7% preferred return on the first quarterly distribution?”
The simple answer is no, especially in multifamily. The reason being is because most of what we buy is value add. To maximize the deal and make a good investment choice, value-added multifamily usually has the ability for the largest eventual gains.
Value creation can take time and money – sometimes as long as 6 months, 18 months or even 24 months but that value needs to be created for the long term investment and dictated by the business plan set forth.
Because of this, often in the first year and potentially even the second year, of owning a multifamily asset, cash distributions can be fairly low. After that it can ramp up fairly quickly and the full preferred return can potentially be paid out in subsequent years of the hold time. However at the very beginning of the acquisition, return percentage can be competing for the same dollars for the value add creation.
Even without the full preferred return being paid out each distribution cycle of the hold period, that amount is still being accrued on the backend. With the value-add component, the gains as well as the pay out of the accrued amount, can be quite hefty when the capital event happens down the line.
Is My 7% Preferred Return Guaranteed?
Nothing in real estate (and life in general for that matter) is guaranteed. However a preferred return is as close to a guarantee that you can get in real estate. Whether the return is paid out quarterly or not, that percentage is accruing and will be paid out at some point in the future.
With any investment in real estate there is a level of risk associated with that investment. Taking a moment to make sure you’re comfortable with that inherent risk is an important first step for any real estate investor. With a solid asset and a top notch team, we believe the benefits of investing outweigh the risk of not doing so.
So when an operator isn’t paying out distributions, does it mean you’re in a bad deal? No. However it does mean you should start asking questions.
Is it because they’re being conservative? That’s not a bad thing. Are they trimming back short term distributions to ensure the health of the long term investment. That’s actually a positive thing to do if it means the long term returns and valuations are protected. Now if it’s because they didn’t plan properly then there are more questions to continue asking.
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