How to pay investors in 1st few months of value-add syndication?

35 Replies

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.


Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

Pref is not a guarantee. It's a hurdle for you to cross before you start taking your share of profits. If the hurdle is not crossed, investors get whatever property produces and you get nothing.

Some sponsors pay whatever is possible and shift any unpaid balance to the next year. E.g. if the first year payout is 6% and the pref is 8%, 2% goes to the next year pushing pref to 10%, and so on. This a recipe for disaster if the property does not perform but the pref keep growing.

That's tough to do if the asset has some repositioning to do first.

One reason why these days we are only after more stabilized/well run businesses that cash flow out of the gate but still have hidden value-add potential.

Exactly what @Nick B. said.  A pref is different than a guaranteed payment.  You distribute 100% of the distributable cash flow thrown off by the property to the investor until they have reached a cumulative 8% return on their capital.  You don't distribute more than the property is earning.

There once was a well-known investor that made a habit of distributing more than the underlying investments were earning.  His name rhymed with "made off," perhaps you've heard of him.  It didn't turn out well for either side...

You can do one of these

1. lower your pref to a 6% 

2. raise more money to pay the pref in the first year or 2

3. Offer no pref in years 1 and 2 and then an 8% pref with no catch up

4. Keep it as is and do what @Nick B. suggests

@Dave DeMink you would pay out the pref as a cumulative return as mentioned above. Most investors will not want to be part of a deal that is non-cumulative. 

For ground up development and heavy value add we use a deferred return model that is cumulative over the life of the deal and pay upon exit. More sophisticated investors prefer this method over a distribution model.

Originally posted by @Dave DeMink :

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.


Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

 Dave, I hope all is well. To achieve a pref the first year on a value add in my opnion you are going to want to raise extra funds to cover the pref for the first couple of years before stable. 

Originally posted by @Chris Salerno :
Originally posted by @Dave DeMink:

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.


Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

 Dave, I hope all is well. To achieve a pref the first year on a value add in my opnion you are going to want to raise extra funds to cover the pref for the first couple of years before stable. 

What's the point of raising extra money only to pay it back, pretending it is a profit? 

Originally posted by @Nick B. :
Originally posted by @Chris Salerno:
Originally posted by @Dave DeMink:

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.


Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

 Dave, I hope all is well. To achieve a pref the first year on a value add in my opnion you are going to want to raise extra funds to cover the pref for the first couple of years before stable. 

What's the point of raising extra money only to pay it back, pretending it is a profit? 

 You are not pretending it is a profit. Your profit on syndication is the sale of the property. 

Syndicators should be running it like a business. Every good business has an operating reserve. You are raising a little more money to hit investors' returns. It all events out. Let me know if you have any more questions. 

Originally posted by @Chris Salerno :
Originally posted by @Nick B.:
Originally posted by @Chris Salerno:
Originally posted by @Dave DeMink:

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.


Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

 Dave, I hope all is well. To achieve a pref the first year on a value add in my opnion you are going to want to raise extra funds to cover the pref for the first couple of years before stable. 

What's the point of raising extra money only to pay it back, pretending it is a profit? 

 You are not pretending it is a profit. Your profit on syndication is the sale of the property. 

Syndicators should be running it like a business. Every good business has an operating reserve. You are raising a little more money to hit investors' returns. It all events out. Let me know if you have any more questions. 

I am all for operating reserve. You use it to pay bills and such if you don't have enough revenues. However, using that reserve to pay distributions makes absolutely no sense. Pref is not interest and is not guaranteed. There is no reason to pay it if the cash flow is not there. 

 

Originally posted by @Nick B. :
Originally posted by @Chris Salerno:
Originally posted by @Nick B.:
Originally posted by @Chris Salerno:
Originally posted by @Dave DeMink:

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.


Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

 Dave, I hope all is well. To achieve a pref the first year on a value add in my opnion you are going to want to raise extra funds to cover the pref for the first couple of years before stable. 

What's the point of raising extra money only to pay it back, pretending it is a profit? 

 You are not pretending it is a profit. Your profit on syndication is the sale of the property. 

Syndicators should be running it like a business. Every good business has an operating reserve. You are raising a little more money to hit investors' returns. It all events out. Let me know if you have any more questions. 

I am all for operating reserve. You use it to pay bills and such if you don't have enough revenues. However, using that reserve to pay distributions makes absolutely no sense. Pref is not interest and is not guaranteed. There is no reason to pay it if the cash flow is not there. 

 

 Each operator is different and runs their business's differently. 

@Dave DeMink

Dave this is a great question and every operator runs their fund a different way.

Personally we only raise enough cash to close and run the property, we don’t like to raise surplus cash.

We offer a 6% preferred return but it is not mandatory and I make our investors clear that our returns are “blended” over the long-term.

Which means they expect a smaller return the first few years as the property is being re-positioned and stabilized, then once that’s done we start to knock it out of the park with higher than expected returns.

So long answer short, talk to your investors, let them know your short term and long term vision and what that means to them and their money, you shouldn’t have any issue and everyone will come out a little richer

Cheers,

Dj

@Dave DeMink this should have been discussed and disclosed prior to closing on the investment. If it's a value add we typically don't make our first distribution until the 2nd or 3rd qtr within the fiscal yr. This alleviates any stress of figuring out how to distribute excess cash flow in the first few months if there are any to distribute. Good luck

I've noticed a trend lately where it seems that a lot of people got confused as to what a preferred return actually is.  Some people (investors and sponsors alike) think that a preferred return is a guaranteed payment--that the money must be paid on a schedule, similar to a loan payment.  That's just not what it is.  A preferred return means that the investor is in a preferred position, in other words, they get priority on the cash flow.  Until the preferred return hurdle is met, investors get 100% of whatever is distributed.  If the preferred return hurdle is 8% and the sponsor pays out 4% in the first year (not at all uncommon in a value-add scenario), the other 4% carries over to the next year and beyond.  For example, let's say that in year 2 the property throws off enough cash flow to pay the investors 8%--the investor gets all of it.  If in year 3 the property throws off enough cash to pay 12%, the investor gets all of it, because the investor is owed 8% for their preferred return, plus the 4% shortfall from year 1.  If in year 4 the property throws off 12% again, the investors get 8% and the remaining 4% drops down to the split tier(s).

The odd and disturbing trend I'm seeing a lot lately is sponsors raising additional capital and making cash flow distributions equivalent to the preferred return hurdle regardless of the performance of the real estate.  The reason I say that it's odd is it is just like saying, "give me $100,000.  I'll invest $85,000 of it in real estate, and I'll give you the remaining $15,000 back in quarterly installments over the first 2-3 years."  Uh, no thanks, I could invest $85,000 with you instead and keep my $15K.

Why would sponsors do this?  I'm not sure, you'd have to ask those that use this practice.  My guess is it is a marketing strategy--a way of attracting capital because you can tell your investor that they will "make" 8% on their money.  I think this is a reason because I had one sponsor ask me, "you don't do that?  How do you raise any money?"  Ugh.

Perhaps some sponsors do it because they don't know how to accrue a preferred return properly, so if they just make the distributions they don't have to track it.  I believe this is a reason because I see so many syndicators make posts on BP about preferred returns that are just wrong.  

In the case of either of these two reasons, as long as it's all disclosed to the investors, no harm, no foul.  But are they disclosing it?  I see so many offerings from sponsors that don't include a sources and uses of funds table.  The investors truly have no idea where the money is going.  Not good.

I suspect that there are also sponsors out there that do this to mask the true performance, obscuring the actual results from unsuspecting investors that don't know any better.  These investors confuse distributions with performance and think that as long as they are getting their distributions, everything is going just fine.  Meanwhile, the property could be in deep trouble and the entity could eventually run out of cash.  Hopefully this isn't happening out there--but I am pretty certain it is from what I've heard from investors that have called me to share their horror stories.

One consideration to not lose sight of is the overall return on the investment is a function of the amount of money raised and the amount of money returned.  This means that raising additional capital for the purposes of distributing it back actually lowers the rate of return for the investment overall.  More dollars in for the same profit out.  So while perhaps the instant gratification of an 8% distribution is nice, it comes at a cost in the long term.

Originally posted by @Brian Burke :

I've noticed a trend lately where it seems that a lot of people got confused as to what a preferred return actually is.  Some people (investors and sponsors alike) think that a preferred return is a guaranteed payment--that the money must be paid on a schedule, similar to a loan payment.  That's just not what it is.  A preferred return means that the investor is in a preferred position, in other words, they get priority on the cash flow.  Until the preferred return hurdle is met, investors get 100% of whatever is distributed.  If the preferred return hurdle is 8% and the sponsor pays out 4% in the first year (not at all uncommon in a value-add scenario), the other 4% carries over to the next year and beyond.  For example, let's say that in year 2 the property throws off enough cash flow to pay the investors 8%--the investor gets all of it.  If in year 3 the property throws off enough cash to pay 12%, the investor gets all of it, because the investor is owed 8% for their preferred return, plus the 4% shortfall from year 1.  If in year 4 the property throws off 12% again, the investors get 8% and the remaining 4% drops down to the split tier(s).

The odd and disturbing trend I'm seeing a lot lately is sponsors raising additional capital and making cash flow distributions equivalent to the preferred return hurdle regardless of the performance of the real estate.  The reason I say that it's odd is it is just like saying, "give me $100,000.  I'll invest $85,000 of it in real estate, and I'll give you the remaining $15,000 back in quarterly installments over the first 2-3 years."  Uh, no thanks, I could invest $85,000 with you instead and keep my $15K.

Why would sponsors do this?  I'm not sure, you'd have to ask those that use this practice.  My guess is it is a marketing strategy--a way of attracting capital because you can tell your investor that they will "make" 8% on their money.  I think this is a reason because I had one sponsor ask me, "you don't do that?  How do you raise any money?"  Ugh.

Perhaps some sponsors do it because they don't know how to accrue a preferred return properly, so if they just make the distributions they don't have to track it.  I believe this is a reason because I see so many syndicators make posts on BP about preferred returns that are just wrong.  

In the case of either of these two reasons, as long as it's all disclosed to the investors, no harm, no foul.  But are they disclosing it?  I see so many offerings from sponsors that don't include a sources and uses of funds table.  The investors truly have no idea where the money is going.  Not good.

I suspect that there are also sponsors out there that do this to mask the true performance, obscuring the actual results from unsuspecting investors that don't know any better.  These investors confuse distributions with performance and think that as long as they are getting their distributions, everything is going just fine.  Meanwhile, the property could be in deep trouble and the entity could eventually run out of cash.  Hopefully this isn't happening out there--but I am pretty certain it is from what I've heard from investors that have called me to share their horror stories.

One consideration to not lose sight of is the overall return on the investment is a function of the amount of money raised and the amount of money returned.  This means that raising additional capital for the purposes of distributing it back actually lowers the rate of return for the investment overall.  More dollars in for the same profit out.  So while perhaps the instant gratification of an 8% distribution is nice, it comes at a cost in the long term.

I network with a group of sophisticated passive investors and this capital inefficiency practice is a red flag and an automatic pass on the offering for every one of them. 

@Mike Dymski

I assume this is OK to do in the instance of cash reserves for property improvements? Hence, Value-add.....I'm not to sure I understand why someone would raise extra capital if it wasn't accounted for as a CAPEX, vacancy, improvement, etc....

Originally posted by @John Hamilton :

@Mike Dymski

I assume this is OK to do in the instance of cash reserves for property improvements? Hence, Value-add.....I'm not to sure I understand why someone would raise extra capital if it wasn't accounted for as a CAPEX, vacancy, improvement, etc....

Yep, that's a green flag.

 

@Brian Burke is it common or uncommon to see actual dollar amount expenses or estimated expenses on the use of funds table.  Or is it best practice to state what the funds could potentially be used for with no dollar amounts?  thank you in advance-

Originally posted by
Originally posted by @Teo Risquez :
@Brian Burke is it common or uncommon to see actual dollar amount expenses or estimated expenses on the use of funds table.  Or is it best practice to state what the funds could potentially be used for with no dollar amounts?  thank you in advance-

Every dollar should be accounted for. Sources and uses tables show where the money is coming from (debt, mezz, preferred equity, and common equity) and where the money is going (purchase price, closing costs, loan origination costs, funding impound accounts, first year insurance, startup costs, legal fees, sponsor fees, cash reserves, and so on).  Each category should show the dollar amount for that item.

Originally posted by @Brian Burke :
Originally posted by @Teo Risquez:
@Brian Burke is it common or uncommon to see actual dollar amount expenses or estimated expenses on the use of funds table.  Or is it best practice to state what the funds could potentially be used for with no dollar amounts?  thank you in advance-

Every dollar should be accounted for. Sources and uses tables show where the money is coming from (debt, mezz, preferred equity, and common equity) and where the money is going (purchase price, closing costs, loan origination costs, funding impound accounts, first year insurance, startup costs, legal fees, sponsor fees, cash reserves, and so on).  Each category should show the dollar amount for that item.

got it thanks! 

Originally posted by @Brian Burke :
Originally posted by @Teo Risquez:
@Brian Burke is it common or uncommon to see actual dollar amount expenses or estimated expenses on the use of funds table.  Or is it best practice to state what the funds could potentially be used for with no dollar amounts?  thank you in advance-

Every dollar should be accounted for. Sources and uses tables show where the money is coming from (debt, mezz, preferred equity, and common equity) and where the money is going (purchase price, closing costs, loan origination costs, funding impound accounts, first year insurance, startup costs, legal fees, sponsor fees, cash reserves, and so on).  Each category should show the dollar amount for that item.

Forgot to ask if you would see these on a PPM? Or once you're in the deal and as part of the quarterly statements?  Thanks again!

Here's how I do it - When I buy it, it's at 10% cap rate which already generates great preferred returns for my investors. It only goes up from here. If you bought right, you shouldn't have to worry about paying your investors even when you just acquired the property. Operating reserves pays for development things and other Capex. You pay your investors with operating cash flow, not their own money.

Originally posted by @Teo Risquez :
 
Forgot to ask if you would see these on a PPM? Or once you're in the deal and as part of the quarterly statements?  Thanks again!

 You should see this before you commit to invest. Otherwise, how do you know how your money is going to be spent?  Never invest in anything where you can’t clearly see where your money is going.

Originally posted by @Brian Burke :
Originally posted by @Teo Risquez:
 
Forgot to ask if you would see these on a PPM? Or once you're in the deal and as part of the quarterly statements?  Thanks again!

 You should see this before you commit to invest. Otherwise, how do you know how your money is going to be spent?  Never invest in anything where you can’t clearly see where your money is going.

 Makes sense, much appreciated!

Create Lasting Wealth Through Real Estate

Join the millions of people achieving financial freedom through the power of real estate investing

Start here