SS106: Preferred Returns vs Cash Distributions

SS106 Preferred Returns vs Cash Distributions

Investors regularly confuse preferred returns with cash distributions. In this episode, Charles explains the difference between them, why there is a variance and how to recognize what the estimated cash distributions will be when reviewing an investment offering.

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Talking Points:

  • In Episode SS103; I discussed what a preferred return is. In this episode, we are going to discuss what is the difference between preferred returns and cash distributions.
  • I was recently speaking with an investor and they were asking why their 1st quarterly distribution was not exactly ¼ of 7% (7% being the preferred return for this deal). The simple explanation is “preferred returns do not equal cash distributions.”
  • The preferred return or “pref” is the minimum percentage before an investment manager can share in the profits. Cash distributions are the actual distributions that are paid out to investors; in other words; the money being deposited into your bank account each distribution period; quarterly distributions are typical. Cash distributions are rarely the same amount each period.
  • Each real estate syndication is different. Properties differ, conditions differ, and problems differ; which requires each syndication to have a different business plan and it takes time for the operators to implement the business plan in order to generate more revenue. In most real syndications though; distributions will increase throughout the investment hold period.
  • I have passively invested in some value-add deals where I have not received any distributions for the first 1 or 2 years and some construction projects do not start paying distributions until year 3 or 4. During this time you may not be receiving a cash distribution BUT YOUR PREFERRED RETURN IS STILL ACCURING; which has to be paid out to you prior to operators sharing in the profit.
    • In one deal, there were no distributions for the first 2 years. The operators had a more aggressive business plan that had them renovating about 5% of units each month. With this type of business plan; you need to retain all cash flow in order to cover operational expenses since you might have consistently a 15%-20% vacancy rate throughout the property during the first 24 months.
      • The reason is when you are performing a value-add business plan and renovating units and the contractor says it will take 2 weeks to renovate each unit; the unit is going to be down for much longer than 2 weeks. First, you need the current tenant to leave, they are not renewing their lease and they move. Second, is assessing the unit and doing the work. Yes, the work might take 2 weeks but they most likely have other units to do first so this unit is just added to their “to-do list.” The third is renting the unit after the renovation has been completed. This whole process could take 2-3 months from the old tenant leaving to the new tenant actually moving in and paying.
      • Typically, this is not what our firm does; we will stagger renovations. We have a contractor that is able to renovate say 4 units per month, and we will then make sure these units are available. If we have more vacancies than the contractor’s capacity; we will clean and re-rent the excess units. In a perfect world, you would have only about 4 vacancies at a time but we might have 4-6 or 4-8 because we want to make sure there is a consistent flow of units for the contractor to renovate. Yes, you could hire another contractor but then there are more down units and less cash flow.
      • It is important to understand that in most value-add projects; you are taking a property that is an operating business and then slightly disrupting it over a 2–3 year period in order to make it more efficient and more profitable.
      • As the property renovation process progresses; units are renovated and re-rented at higher rates. Cash distributions will then steadily rise over the hold period.
    • How do I know what the potential cash distributions will be in a deal:
      • When reviewing an investment offering; you will see a preferred return and then you will see a section named “projected returns” or simply “returns.” This section will have the projected returns over the hold period. If it is a projected 7-year hold; there will be a column for each year. In each column; you will see a cash-on-cash return for that specific year; that is where you can find and review the estimated cash distributions.
    • Most of our value-add deals will have a 7% or 8% preferred return with a cash-on-cash return that will begin around 5% in year one and grow from there. Usually by year 2 or 3; the cash distributions are exceeding the preferred return.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing preferred returns versus cash distributions.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Charles:
In episode SS 103, I discussed what a preferred return is. In this episode, we’re gonna discuss what is the difference between preferred returns and cash distributions. I was recently speaking with an investor and they’re asking whether first quarterly distribution was not exactly a quarter of 7%, 7% being the preferred return for this deal. The simple explanation is preferred returns do not equal cash distributions. The preferred return or pre is the minimum percentage before an investment manager can share in the profits. Cash distributions are the actual distributions that are paid out to investors. In other words, the money being deposit into your bank account each distribution period. Quarterly distributions are typical, and cash distributions are rarely the same amount each period. So each real estate syndication is different. Properties differ, conditions differ, problems differ, which requires each syndication to have a different business plan, and it takes time for the operators to implement the business plan in order to generate more revenue. In most real estate syndications, though distributions will increase throughout the investment whole period.

Charles:
I’ve passively invested into some value add deals where I’ve not received any distributions for the first one or two years, and some construction projects do not start paying distributions until year three or four. During this time, you may not be receiving a cash distribution, but your preferred return is still accruing, which is very important, which has to be paid out to you. Prior to operators sharing the profit in one deal, there were no distributions. For the first two years, the operators had a more aggressive business plan that had them renovating about 5% of the units each month. With this type of business plan, you need to retain all cash flow in order to cover operational expenses, since you might have consistently a 15 to 20% vacancy rate throughout the property during the first 24 months. Now, the reason being is when you’re performing value add business plan and renovating units, and the contractor says it’ll take two weeks to renovate each unit, the unit’s gonna be down for much longer than two weeks.

Charles:
First, you need the current tent to leave. They’re not renewing their lease and they move. Second is assessing the unit and doing the work. Yes, the work might take just two weeks, but they most likely have other units to do first, and this unit is just added to their to-do list. Third is renting the unit after the renovation has been completed. Now the whole process could take two to three months from the a tenant leaving to the new tenant actually moving in and paying because when someone’s wants to move into apartment it might not be for three weeks down the road or a month down the road or even more. So you have to take this into consideration. Typically, this is not what our firm does. We will stagger renovations. We have a contractor who’s able to renovate, say four units per month, and we’ll then make sure these units are available for that renovation.

Charles:
If we have more vacancies than the contractor’s capacity, we will clean and re-rent the excess units. In a perfect world, you would only have about four vacancies at a time, but we might have four to six or four to eight because we wanna make sure there is consistent flow of units for the contractor to renovate. You don’t want them waiting for units to renovate. Yes, you could hire another contractor, but then there is more down units and less cash flow. It’s also more construction to manage is important to understand that in most value add projects, you are taking a property that has an operating business and then slightly disrupting it over a two to three year period in order to make it more efficient and more profitable. As a property renovation process progresses, units are renovated and re-rented at higher rates. Cash distribution will then steadily rise over the whole period.

Charles:
So how do I know what the potential cash distributions will be in a deal? Well, when reviewing an investment offering, you will see a preferred return, and then you will see a section named projected returns or simply returns. And this section will have the projected returns over the hold period. If it is a projected seven year hold, there will be a column for each year, and in each column you will see a cash and cash return for that specific year, and that is where you can find and review the estimated cash distributions. Obviously, these are all estimates. It’s all proforma, but it’s what they’re thinking with what their business plan is including now, most of our value ideals will have a 7% or 8% preferred return with a cash on cash return that will begin around 5% year one and grow from there. Usually by year two or three, the cash distributions are exceeding the preferred return. So I hope you enjoyed. Please remember, rate, review, subscribe, submit comments and potential show topics at globalinvestorspodcast.com. Look forward to two more episodes next week. See you then.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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