Preferred Return Question

[Christian Nachtrieb]

Question regarding offering private money investors a preferred return... is this figure based on the net income the property produces after operating expenses? If so, I'm assuming then that you would run through those budgets (vacancy, capex, maintenance, etc.) beforehand correct? 

Thank you!

[Theo Hicks]

@Christian Nachtrieb

Total income collected = gross potential rent + other income - all revenue loss line times (i.e. vacancy loss, loss-to-lease, concessions, discounted units, and bad debt)

Operating Expenses = ongoing operational expenses (i.e. payroll, maintenance and repairs, contract services, make ready, advertising/marketing, administrative, utilities, management, taxes, insurance, reserves, etc.)

Debt service = annual payment for the loan (principal and interest)

When you identify a new opportunity, you underwrite the deal, and the results of your underwriting is a preliminary budget. Then, if you put the property under contract, you perform due diligence to confirm/update your budget. The budget will have a projected cash flow for each year you plan on holding onto the property, which you use to calculate the projected cash flow to your investors (based on the preferred return, profit split, or however you structured the partnership).

Typically, once you close on the deal, you distribute the preferred return, which is a percentage of the equity investment (i.e. if someone invested $100,000 and you are offering a 8% preferred return, you would distribute $8k for the year, either quarterly or monthly). Then, if you are under-budget, you can distribute the extra cash flow to the investors (usually, it is based on a profit split). If you go over budget, hopefully you still have enough cash flow to cover the preferred return. If not, the preferred return will accrue and you will need to distribute it either in a future year or at sale.

Note: all of this is for apartment syndications but the same should hold true for any partnership with a passive investor.