I am getting ready to syndicate my first deal. I am offering my handful of investors an 8% preferred return and a 60/40 split thereafter. The deal will yield a 15% annual cash on cash return and I expect to hold it for five years where the overall IRR should be upwards of 30%.
Do I distribute all of the 15% each year and take my 40% of the profits above the preferred return? Or do I just distribute the 8% preferred return and keep the excess cash flow as retained earnings which would then get distributed at the time of sale five years from now. I haven’t discussed this part with the investors yet because I’m not sure what is the most common method.
If you deliver 15% cash on cash returns AND north of a 30 IRR I hope you write a book to teach all of the rest of us how you did it, because I haven't done that in 30 years and 750 tries (well, 30+ IRR a couple of times, never 15% CoC and certainly never both). Nevertheless, that doesn't answer your question...
It depends on how your operating agreement is worded, and whether your preferred return hurdle is an IRR or an annual return.
If your pref is to an 8% annual return, once the preferred return tier is satisfied any distributions that exceed that hurdle would be handled one of two ways (assuming you don't have a catch-up provision). 1. It drops to the split tier, meaning you get 40% of it. 2. It goes 100% to the investors until all of their capital has been returned, then after that it drops to the split tier.
If your operating agreement uses method 1, you'd probably have a separate provision that directs cash proceeds from a refinance or sale to investors until their capital is returned, then to the split tier after that.
If your preferred return is to an 8% IRR, that changes everything. To hit a positive IRR you have to have returned all capital plus the return, and nothing drops to the split tier until that hurdle has been met.
So the bottom line is it's your choice, just be sure that your operating agreement language matches your math.
@Brian Burke thanks so much for the feedback. As far as this particular deal is concerned I found a needle in a haystack. I'm getting it at an 8% cap rate based on 50% occupancy at market rents. I'm drafting up the financial terms of the operating agreement and splitting of cash flows is the only thing I haven't outlined yet. I'm trying to keep it as simple as possible. I think I'm leaning towards an 8% annual return hurdle with a catch up provision.