Analyzing Syndication Deal - Return on Capital?

Multi-Family and Apartment Investing
4yFollow

Analyzing Syndication Deal - Return on Capital?

Danny L.
Investor · Bay Area, CA · Member since 2022 · 8 posts · 3 votes
Hello all,

I'm currently looking at a potential MF syndication deal. I started investing in syndication this year and have been learning through books, online, and various podcasts. One of the things I came across was determining if the deal was based on Return on Capital or Return of Capital.

Looking at the PPM for this deal, I couldn't figure out which method they were using. I searched the document for either phrase and came up with nothing.

The closest section I've found is this:

(i) Net Distributable Cash shall be distributed quarterly on the following basis:
a. First, to Class A Members, a 9% Preferred Return,
b. Second, pari passu to Class B Members, a 7% Preferred Return, to Class C Members, an 8% Preferred
Return, to Class D Members, a 9% Preferred Return, and to Class E Members, a 10% Preferred Return,
in each case in proportion to each Member’s respective Preferred Return Balances until each such
Member’s Preferred Return Balance is reduced to zero;

My guess is "until each such Member’s Preferred Return Balance is reduced to zero" would indicate distributions are based on Return of Capital.

I'll appreciate if someone with experience on this topic can confirm if my interpretation is correct.

Thank you.


1Reply
46 views

Most Popular Reply

Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
4y

@Danny L., glad you are enjoying the book!

This appears to be a case where distributions are return ON capital first. It isn’t the best drafting, but one clue is where it says “Distributions of the Preferred Return do not reduce a Member’s Capital Account.”  That isn’t true, distributions always reduce a member’s capital account, but I think what they meant to say here is that distributions don’t reduce a member’s capital balance.

Another clue is that the preferred return is calculated using annualized return, not IRR. In the case of an IRR hurdle, all capital must be returned in order to hit it. That doesn't change much from a practical perspective until the percentage is exceeded—it just delays going to the next tier until capital is returned, that's all.

Another clue is that if preferred return is based on an annualized return, the waterfall language would have to say something like, "first, to the Class B Member to the extent of their unreturned capital," if the first distributions were to be return OF capital. This one doesn't say that—it says first to preferred return, and we now know the preferred return is not IRR.

You might also want to look up the definition of “Capital Return” because it’s mentioned in the definition of Preferred Return, just to see if that alters anything.

Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
2Reply
See this reply in the discussion

8 Replies

Jump to latestLatest
  • Luke Grieshop
    Investor · Scottsdale, AZ · Member since 2017 · 56 posts · 18 votes
    4y

    I could see where you're drawing that interpretation from the language shared here. 

    Probably a dumb question, but did you ask the sponsor? If you have a feeling they'd lie about it, may not be a good investment in the first place :/ 

    0Reply
  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    4y

    @Danny L., not enough information here to answer.

    First, what do you mean by “deal was based on Return on Capital or Return of Capital”? Are you asking if distributions are first return OF or return ON?

    Also, notice that the words “Preferred Return” and “Preferred Return Balance” are capitalized. This means that somewhere else in the agreement you should find the definitions of these terms, usually in a definitions section at the beginning of the agreement.  Can you paste those definitions here?

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
    0Reply
  • Danny L.
    OP
    Investor · Bay Area, CA · Member since 2022 · 8 posts · 3 votes
    4y
    Quote from @Luke Grieshop:

    I could see where you're drawing that interpretation from the language shared here. 

    Probably a dumb question, but did you ask the sponsor? If you have a feeling they'd lie about it, may not be a good investment in the first place :/ 


    Hi Luke,

    I will be asking the sponsor to see what they say. I was just checking if it was something that I missed because I'm new to syndication and someone who has done multiple deals may be able to recognize from the verbiage if distributions was "Return on" vs "Return of" capital.

    I don't think the sponsor will lie about it as that wasn't my reason to post here but ideally I would like to learn enough to scan through multiple PPMs from different syndicators and determine if distributions are "Return on" vs "Return of" capital without waiting to connect with the sponsor for answers. : )



    0Reply
  • Danny L.
    OP
    Investor · Bay Area, CA · Member since 2022 · 8 posts · 3 votes
    4y
    Quote from @Brian Burke:

    @Danny L., not enough information here to answer.

    First, what do you mean by “deal was based on Return on Capital or Return of Capital”? Are you asking if distributions are first return OF or return ON?

    Also, notice that the words “Preferred Return” and “Preferred Return Balance” are capitalized. This means that somewhere else in the agreement you should find the definitions of these terms, usually in a definitions section at the beginning of the agreement.  Can you paste those definitions here?


    Hello Brian,

    Small world...I'm in the middle of listening to your book "The Hands-Off Investor". It was you who presented this concept as I caught this bit while I was driving in my car and made a mental note that I must check every future deal on this.

    Yes, I was asking if distributions are Return on Capital or Return of Capital. I did find the definitions for “Preferred Return” and “Preferred Return Balance” below.

    “Preferred Return” means, (i) as to each Class A Member, a sum equal to 9%; (ii) as to each Class B Member, a sum
    equal to 7%; (iii) as to each Class C Member, a sum equal to 8%; (iv) as to each Class D Member, a sum equal to 9%,
    and (v) as to each Class E Member, a sum equal to 10%, in each case per annum non-compounded times the amount of
    the Net Capital Contributions of such Member calculated quarterly. The quarterly calculation to begin on the first day of
    the month following the completion of the first quarter after the purchase of the first Property, to be paid to the extent that
    (i) the Company has sufficient Net Distributable Cash to pay such Preferred Return, and (ii) the Manager elects, in its sole
    discretion, to make such payment or defer such payment to a later date. The Preferred Return is retired as to each Member
    once he, she, or it achieves a Capital Return. Distributions of the Preferred Return do not reduce a Member’s Capital
    Account. Any funds received in a Capital Call that are not deployed in the purchase of a Property (“Non-Deployed
    Funds”) shall not accrue the Preferred Return, but rather, shall bear interest at a rate of 2% per annum non-compounding,
    accruing from the date of when funds are deployed (“Deployed Funds”) from such Capital Call until such time as the
    Company deploys the Non-Deployed Funds into a subsequent Property.

    “Preferred Return Balance” means amounts owed under the Preferred Return, including amounts accrued but not
    distributed.





    0Reply
  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    4y

    @Danny L., glad you are enjoying the book!

    This appears to be a case where distributions are return ON capital first. It isn’t the best drafting, but one clue is where it says “Distributions of the Preferred Return do not reduce a Member’s Capital Account.”  That isn’t true, distributions always reduce a member’s capital account, but I think what they meant to say here is that distributions don’t reduce a member’s capital balance.

    Another clue is that the preferred return is calculated using annualized return, not IRR. In the case of an IRR hurdle, all capital must be returned in order to hit it. That doesn't change much from a practical perspective until the percentage is exceeded—it just delays going to the next tier until capital is returned, that's all.

    Another clue is that if preferred return is based on an annualized return, the waterfall language would have to say something like, "first, to the Class B Member to the extent of their unreturned capital," if the first distributions were to be return OF capital. This one doesn't say that—it says first to preferred return, and we now know the preferred return is not IRR.

    You might also want to look up the definition of “Capital Return” because it’s mentioned in the definition of Preferred Return, just to see if that alters anything.

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
    2Reply
  • Danny L.
    OP
    Investor · Bay Area, CA · Member since 2022 · 8 posts · 3 votes
    4y

    @Brian Burke Thank you so much for taking the time to look into this. You gave so much information here and it looks like I need to work on gaining a deeper understanding of the language used in syndications & PPMs to evaluate them properly. I hope others can used this information as well if they are considering syndication deals. I appreciate you sharing your expertise with me.

    1Reply
  • Brock Mogensen
    Real Estate Syndicator · Milwaukee, WI · Member since 2018 · 1k+ posts · 907 votes
    4y

    Tough to answer without more detail, but as others pointed out the sponsor will be able to answer this question. Based on the amount of share classes, it's going to be a more complicated structure to figure out.  Good to see you are digging into the details though, it's complicated stuff but essential to understand as an LP to ensure you are investing in the right deal.

    0Reply
  • Paul MoorePro Member
    Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes
    4y

    @Danny L. you got a great answer from Brian above. Your question essentially regards whether the Sponsor is using a European or American waterfall. The European model returns all investor capital first.  American returns profit first. Neither is necessarily better though some would argue with me on that.  

    Because of bonus depreciation, it is likely that the first several years of returns will not be immediately taxable under either structure. Under European, return of capital is obviously not taxed.  Under American, early depreciation can defer taxes on income. 

    Happy Investing!  

    Podcast Guest on Show #533
    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free