It’s an exciting day when you hear the ping of a new email and it’s an alert for an open deal with Goodegg Investments! You start reading through the investment summary and the numbers are looking really great. However you’re not quite sure what some of those numbers mean for you as the passive investor and what amount will actually be hitting your bank account each month or quarter in terms of distributions.
This is a hot button topic for new and seasoned investors alike. It can sometimes be a bit confusing deciphering what the difference is between income, accruals, and preferred returns – and understanding what those numbers mean to you as the investor.
In this article we’ll break down the returns a passive investor can see and how quarterly distributions differ from accrued income. With this information we hope to give you a demystifying look into this important topic.
Let’s start with the basics.
Income As Distributions In Syndications
Simply put, income is money coming to you that you’ve received either from a W2 job, a 1099 or as a distribution from a real estate investment – like what we do in syndications. When your money is in a real estate syndication, the income you receive is called a distribution. These monthly or quarterly funds go directly back into your pocket as a limited partner investor.
However, some deals are structured to have these distributions accrue over time. We’ll dive deep into accruals (the term used to describe distributions building up over a period of time) down below, but the basic definition of accrued income is distributions that are withheld and distributed at a later date.
We all enjoy that money hitting our bank accounts. The feeling of receiving money passively from our investments is a keystone to financial freedom. It can give us peace of mind, room to explore our interests and hobbies, or the runway to start that next business.
This income is a big deal for many of our investors – ourselves included. Having these passive distributions is what allows many of us to live our dream lifestyle.
No matter who you are, when you’re investing into a passive investment, you’re looking for a potential new income stream. There is a good chance that your eyes head straight for those distribution percentages when reviewing new investment summaries. These distributions can range anywhere from 3-6%, to even 10% in our hotel deals. These percentages are also called the preferred return.
Income From The Sale Of A Syndication
In addition to potential distributions throughout the hold time, there is usually a large payout that happens at the end of the lifecycle of the deal when it comes time to sell the property, typically between 3-5 years.
For a passive investor, distributions plus proceeds from the sale of an asset are the ways that income is made during the lifecycle of a real estate syndication deal. Keep in mind that those distributions are subject to the true cash flow of those individual assets. If an asset suddenly needs a major, unexpected repair, then funds may need to be diverted to repairs rather than distributed to owners as cash flow.
So what happens when the true cash flow of the asset doesn’t allow for those distributions to be made at that time?
Luckily, those distributions are paid at a later date.
The preferred return, or distribution percentage, is being accrued so that the investor is still earning their income, it will just be paid out at a later time. This is accrued income.
What Is Accrued Income?
Accrued income is when the money you’re making on distributions is being earned but isn’t being paid out into your bank account just quite yet. An easy way to think about it is below:
Accrued Income = Money You’re Earning (i.e. the amount that will paid out to you at a later date)
Income = Money That Is Actually Being Paid Out (i.e. distributions that are hitting your bank account)
Let’s say you’ve placed $100k into an investment with an annual preferred return of 7%. If that investment is held for 5 years you will most likely earn $35k on your $100k.
$100k initial investment x 7% = $7,000 x 5 years = $35k
It’s important to note that the preferred return will begin accruing at the time your money is allocated to an investment.
The preferred return is non-compounding and thus the accrual is also non-compounding. It’s an annual return based on the preferred return of your invested capital. The appreciation that can come when selling the asset can be when the larger gains are realized.
A Deep Dive Into Accrued Income
Now let’s break this down even further to account for the real cash flow that the asset is realizing to see how accruals work.
Let’s say in the first year of owning that asset you earned a 7% return (i.e. $7,000). However the true income/cash flow of the asset can only allow a pay out $3,500 of that return, the remaining $3,500 will accrue and eventually get paid out to you. This is accrued income. That $3,500 is your money and it’s important to remember that you’re continuing to earn on your investment, even if the full preferred return isn’t being paid out every month or quarter.
When you invest your money with us, or anyone for that matter, your money is actively earning from day one after an asset is purchased. Whether it gets paid out in a consistent distribution every quarter or paid out at another time period, as long as it’s accruing, you’re earning.
Now let’s envision the worst case scenario.
Your $35k has been accrued but no distributions have been paid out during the hold period. Not ideal for most of us. Likely, the asset’s cash flow hasn’t been sufficient to pay out distributions. Perhaps a global pandemic hit, or a record-breaking storm (and the damage caused by it).
Hopefully along the way the sponsor has been communicating with you as to what is going on and explaining why those distributions aren’t happening. If not, that is a large red flag. As an owner, you deserve to know what is happening to cause this situation.
In this scenario, we now have a capital event that happens, such as the sale of the asset or a refinance. At this point, the gain (or accrued income) will be recognized. The accrued preferred return (in this example $35k) will be paid out as well as any other equity gain from the sale or refinance. As a preferred return, these funds go to investors before the operator team takes any profits.
This is the beauty of accruals and why it’s so important to understand what’s happening with your investment.
A Real World Example
Let’s talk about a real world example from within our own portfolio – a property in Jacksonville, Florida, that was held for 3 years. During that time there were only minor distributions paid out due to factors at the property that directly affected the real time cash flow. Even though the full preferred return in the form of distributions weren’t being paid out during the 3 years, each of our investors were earning their accrued preferred return the entire time.
The appropriate time came in the market to sell the asset. All preferred returns that hadn’t been paid out during that time (i.e. the accrued income) were paid out first in a lump sum. Let’s look at the numbers.
On a $100k investment held over 3 years, the investor received $35k of distributed and accrued preferred returns. They then received their original $100k investment back. To top it all off, they also received their percentage of the profits. These returns yielded our investors a 2.2x equity multiple. With a $100k original investment the investor ended up with $220k at the end of a 3 year hold period.
More than doubling their money in 3-years never looked so easy.
The Real-World Stats
- Multifamily property in Jacksonville, Florida
- Hold time: 3-years
- Minor distributions paid during the hold time, most held in accrual
- Upon sale, 2.2x equity multiple realized by investors
- At a $100k investment, $220k returned (original capital, accrued distributions, and proceeds from sale)
Through this example it can be helpful to understand that even though you may not be seeing distributions on a monthly or quarterly basis, it doesn’t mean they aren’t accruing in the background. To clarify further, the accrued income won’t only be paid out through a capital event. The accrual could be paid out within two or three quarters from the time it was paused. The distribution can potentially be paid out once the cash flow on the asset is reconciled.
How To Plan For Your Distributions When Investing In A Syndication
Making an informed decision when evaluating a potential investment is the first step. If the investment summary lists a 7% preferred return but the cash flow will be around 3 or 4% in year one and two, you know an automatic accrued return will be paid out to you at a later date.
Once you see that the business plan incorporates an accrual, you would then look at how long that accrual is expected to be. Does the accrual last the entire hold period? Or just during those first two years and then begins paying out the full pref in years 3-5?
Armed with these questions and answers, you can make informed decisions about your investments and personal income projections.
My Quarterly Distribution Wasn’t Paid Out, Am I In A Bad Investment?
Nope! You’re most likely not in a bad investment and we’ll explain why.
Let’s say for the first year or two you’re receiving the expected quarterly distribution and then all of a sudden it stops. Should you immediately try to pull your money out? Again, nope.
Through the monthly investor updates sent out, any change to the distribution schedule should have been communicated. Through this update any pertinent information will have been relayed to the investor. Such as why the pause is happening and how long the pause is expected to last.
If there are still questions, the first thing to do is to pick up the phone and call the investor relations team. They’ll be able to communicate directly with you what’s happening and why. There is usually a good reason as to why those distributions are paused and at Goodegg we’re always happy to hop on a call to discuss.
Other Ways Distributions May Be Accrued
As we all know, interest rates can rise during the hold period of an asset. On some of our properties, cash flow has been affected by this change. What it doesn’t affect is the accrued return that is still being earned for our investors. These changes in the market also don’t affect the overall buyability and overall revenue side of the asset itself.
Luckily, valuations – or sale prices – aren’t based on free cash flow, or cash left in the bank account. When you go out to the market to purchase a property it doesn’t matter if there is $10k or $300k left at the end of the month for cash flow. What does matter is the NOI (Net Operating Income – the revenue minus the basic expenses of the property). The sale price is determined by taking the NOI and dividing by the current market cap rate.
So it’s important to remember to not use short term income and distributions as your to determine if a deal is good or not. Instead look back at why you invested in the first place.
If you trust the group you invested with and you were comfortable with the deal from day one, then have the confidence that they will do what is best for your capital. The caveat is that if you start to feel that the group you invested with is doing something that you feel very uncomfortable with, then get on a call with them and find out what’s going on. Communication is key throughout any investment you’re part of. If the sponsor isn’t doing anything negligent, then they shouldn’t have any problem being in touch and answering your questions.
Proforma vs Actual Distribution
A question we get quite often is, if my distributions are paused for any length of time during the hold period of the deal, do I lose that amount? The answer is no. Let’s dive deeper.
The amount that is accrued is your money and will be paid out. From here, you will want to know when that accrued preferred return will be paid to you.
Let’s say you have that 7% return and you’re being paid out at 4%, that additional 3% is getting accrued and is on the books. What that means is that you will get the money when the cash flow at the property allows for it. That may be the next month, or upon sale of the asset. It’s just a matter of time when that amount will be paid, there is no point in time where that money is lost.
Similar to a CD (Certificate of Deposit) you’re entrusting us with the money to hold while you’re accruing a percentage during the hold time. In the best case scenario for our deals, unlike a CD, we can most often also pay out a distribution on top of that accrued return. However sometimes those distributions will pause while you’re still accruing the 7%, again unlike a CD where all you’ll be gaining is around 1-1.5%.
Some investments, such as our hotel deals, have the potential for strong cash flow right from day one. We can potentially pay out 10-12% within a short time after acquisition. With an element of value-add to most of our multifamily acquisitions, the cash flow is usually tighter at the early stages of ownership. However, there is potential for large equity gains by adding that value. Having a diversified portfolio of assets can keep you balanced through all market cycles.
Protecting Investors Capital
It’s helpful to keep in mind that real estate is not a “get rich quick” investment. But it can be a powerful wealth building vehicle.
Assets are typically held for at least 3-5 years. This time span accounts for any potential ups or downs that might happen, with the end goal of asset appreciation and capital preservation. If the goal is to optimize appreciation and preserve capital, distributions may need to be paused for a short period of time. You’ll want to feel confident that we, or any sponsors you’re working with, are making the best decisions.
Here at Goodegg Investments, we have a variety of options for you to help you learn about and invest in real estate so you can take advantage of the cash flow, equity, appreciation, and tax benefits. Below are a few resources to get you started.
If you’re accredited and ready to invest right now, we invite you to check out our open deals page to learn more about our current or upcoming opportunities.
If you’re not yet ready to invest but are curious about how all of this works, we invite you to dip your toe in the water with us through our free 7-day email course – Passive Real Estate Investing 101 – or to get a free hardcover copy of our book – Investing For Good.
Connect With Us
If there’s ever anything we can do to help you on your journey, feel free to email us at [email protected] or call / text us at (888) 830-1450.