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

[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

[Jesse Daconta]

We're in a similar situation. We just told our investors that they are accruing at 8% each year for the first 3 years but that they would need to accept 4% per year (towards the 8% yearly) for the safety of the property and everyone's funds. They still get some interest money for the first 3 years and they get everything that's owed/principal at the refinance

[Alina Trigub]

Brian,
The pref doesn't have to be cumulative. While it's a common practice that if the offering has a pref to make it cumulative, I've seen some PPMs stating it's not. Another reason to read the PPM's carefully. 


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.

[Joshua Davies]

I have also seen instances where syndicators will over-raise capital just to pay their investors 8% from the get go. I had this suspicion for a while, and it was confirmed when looking through income statements and balance sheets of certain syndicators, which did not support anywhere close to 8% returns. 

I guess this, unfortunately, has become common practice. Many syndicators come from professional backgrounds not related to real estate investment/finance, and it can really show.

With that being said, providing actual returns to investors does give us syndicators and fund managers a chance to distance ourselves from the competition.

[Kyle Mitchell]

@Dave DeMink You need to be sure you understand the difference between Return of Capital vs Return on Capital.  You don't necessarily need to payout the 8% pref immediately and once the property is stabilized and at the 10-11% you mentioned you can increase the payouts so you "catch up" on the balance owed from the pref at a later date.  The key here is the communication to your investors explaining why there is lower returns to start for a value add play (easy enough to do).  As long as your business plan and communication to your investors is clear then you should have no issues paying out lower in the first 6-12 months until you can hit that preferred return once stabilized.  

[Noah Swank]

@Dave DeMink

We’ve done this when we had sufficient reserves in place and knew the overall timeline would support the cash flow. We’ve also delayed prefer for a year or two before any coupon starts but either is always spelled out in the deal before it strikes.

[John Casmon]

Great dialogue in this thread. What I will add is some deals have sufficient cash flow to begin making distributions to investors. If you've raised for all CapEx, reserves and are buying a true value-add property that is generating cash flow out of the gate, I don't see distributing that cash flow (not reserves/CapEx) to investors as much of a concern.

[Dave DeMink]

WOW - thank you BP community for taking what might have been a simple question for most and making it crystal clear for me.

[Dave DeMink]

@Kyle Mitchell - thank you for the clarity.  This thread has been an incredible learning experience.  Thank you for your input and certainly the path we will take

Originally posted by @Kyle Mitchell:

@Dave DeMink You need to be sure you understand the difference between Return of Capital vs Return on Capital.  You don't necessarily need to payout the 8% pref immediately and once the property is stabilized and at the 10-11% you mentioned you can increase the payouts so you "catch up" on the balance owed from the pref at a later date.  The key here is the communication to your investors explaining why there is lower returns to start for a value add play (easy enough to do).  As long as your business plan and communication to your investors is clear then you should have no issues paying out lower in the first 6-12 months until you can hit that preferred return once stabilized.  

[Kevin Manz]

@Brian Burke Great explanation. Learned a ton from it. Is there only 1 sponsor, or can there be multiple? Does sponsor put any of there own money into a syndication? Say a sponsor puts in 100k of there own money, would that 100k be eligible for the preferred return amount? Thanks for your expertise.

[Brian Burke]

@Kevin Manz yes generally there is only one sponsor (but sometimes the sponsor has multiple principals or partners).  Sometimes sponsors invest in their offerings, sometimes not.  If they do, they are either participating as if they were an investor, which means they are subject to the same terms as everyone else including preferred returns, or they invest separately and have a 100% claim on the pro-rata entity-level cash flow which makes a preferred return on their capital moot.