Education

How Passive Investors Make Their Returns

By Matt Picheny

In this article, we’re going to look at how returns work for passive investors in a real estate syndication, so you can see how they actually make money from these deals. We’ll cover cash flow, capital events, carried interest, distributions, preferred returns, and the important distinction between return of capital and return on capital.

Distributions

Passive investors in a syndication get paid through distributions. There are essentially two types of events that will trigger a distribution.

The first is cash flow. This is the profit that is generated from the property’s normal day-to-day operations. A property that is performing well will typically make these distributions on a quarterly or monthly basis.

The other reason for a distribution is a capital event. This would be from a large influx of capital due to either the refinance or the sale of the property.

Equity Split

The amounts being distributed depend on how the equity in the deal has been structured.

Investors will typically have a percentage of the equity in the deal. This is often 70% to 80% but I have seen deals as low as 50%.

The Sponsors get the remaining percentage of equity as a reward for all their efforts in finding, assembling, and operating a successful project. This is often referred to as “Carried Interest” or “Sweat Equity”.

I often invest in deals that use set amounts of equity but some are structured in a “waterfall” arrangement, where the Sponsor’s percentage increases if certain metrics are achieved.

While I tend not to invest in deals that give the investors less than 70% of the equity in a deal, I ultimately don’t really mind if the sponsor gets a higher proportion of the deal so long as I’m confident that the deal will be a success. What’s most important is that I’m satisfied that my return is going to meet my goals.

For example, at the outset of a deal, I might have this goal in mind:

“This deal will allow me to double my money in 5–7 years, and it will have strong cash flow during the time we own the property.”

If I’m confident that we’ll achieve that, the exact amount the sponsors take won’t concern me.

Preferred Returns

Some deals use preferred returns to determine how cash distributions are paid to investors and sponsors. With a preferred return, the investors get paid first, at an agreed percentage. This is best explained with an example.

Say there’s a deal with an 80/20 split and an 8% preferred return.

If the property distributes only 7% from cash flow in year one, that’s below the preferred return percentage and so all of those distributions go only to the investors — the sponsors don’t get paid anything in distributions.

But if the deal instead distributed 12% in year one, that’s above the preferred return percentage and so both the investors and the sponsors would be paid. In keeping with the 80/20 split, the investors would get 80% of the distribution (that’s 9.6% of the 12% total). As this is above the 8% threshold of the preferred return, the remaining 2.4% would be paid to the sponsors.

Pro Tip: Preferred returns can be smoke and mirrors, depending on whether distributions are set up as a return of capital or return on capital. So let’s take a look at that.

Return Of Capital vs Return On Capital

You might not think that a single word — “of” or “on” — would make a difference in an investment, but it’s important to know that return of capital is not the same as return on capital.

If you don’t know that this difference exists and what it means, that could be the recipe for getting into a deal that’s not as profitable as you think.

Let’s look at what this all means. The key is to keep in mind that the amount you invest in a deal is known as your “capital contribution” and that these two types of deal structures treat that contribution differently.

Return Of Capital

In a “return of capital” scenario, the amount you invested in the deal — your capital contribution — is reduced by the amount of each distribution. As an investor, your returns during the deal are deducted from that capital contribution.

Say your investment is $100,000. Over the course of the deal, you receive $40,000 in distributions. That means your capital contribution is reduced by that amount, taking it down to $60,000.

If the deal was then sold, you would get the $60,000 remaining from your capital contribution returned to you. Everything after that would be considered profit and be subject to the investor/sponsor split.

If you have a return of capital deal and a preferred return, the preferred return isn’t really all that relevant. Assuming the deal is profitable, the investors’ capital would be returned (minus the distributions they already received) and the profits are split. The profit is the same but the preferred return just means the investor got paid some of their money a little bit sooner.

Return On Capital

In a “return on capital” structure, distributions are not deducted from your capital contribution. If you invest $100,000, that’s your capital contribution for the whole deal.

At the sale, you receive the full $100,000 before the investor/sponsor split starts, regardless of what the distributions were during the deal.

Unlike with return of capital deals, preferred returns can matter when a deal is structured with return on capital.

So, considering both options, return on capital must be a better deal, right?

It might seem that way at face value, and we could say that, generally, return on capital is more advantageous for the investor.

BUT the overall makeup of the deal is what matters.

For example, I modeled a scenario that looked like this:

  • $100,000 investment
  • 5 years
  • 10% distribution each year
  • Return On Capital
  • Investor/Sponsor split of 70/30

In this scenario, the investor’s total profit would have been $99,000.

But when I used the same scenario and changed distributions to be a return of capital deal and made it a 80/20 split, the investor’s total profit would be almost the same at $98,000.

The lesson here is that you have to look at all of the factors that make up the deal to work out whether it’s really as attractive as it might appear.

I tend to work with return of capital deals, but when the conditions have been right, I’ve invested in return on capital deals, too. As always, understanding the market, the deal, and the sponsors is essential in improving your chances of success.

Hopefully, you’ve done a good job vetting your sponsor and steered clear of anyone who might try to hide the type of deal you’re being offered. Whether a deal is return on capital or return of capital should be defined in the operating agreement — one of the legal documents that you have to sign as part of the deal.

The key thing is to understand that there’s a difference and to know what sort of deal you’re investing in. Most people don’t know about these differences, and it’s possible that some unscrupulous sponsors could put them into a deal that doesn’t favor them.


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