All Forum Posts by: Ryan Windus

Recently, a lot of the value-add deals we have been underwriting will produce less cash on cash returns during the beginning years of the project than the deal's preferred return. Whether talking to potential investors, or looking to do a passive investment yourself, I wanted to share an overview of how preferred returns impact your cash flow as an LP investor. 

 A common misconception is that preferred returns are a representation of how much of a cash on cash return an investor can expect to receive upon every distribution. While both important to investment metrics, preferred returns have separate implications for distributions than the projected cash on cash return to investors.

Preferred Returns

Preferred returns relate to the waterfall structure of how cash flows from the underlying asset are distributed between limited partners (LPs or investors) and the general partner (GP or the sponsor). A preferred return is a minimum return threshold provided to investors prior to the payment of any performance compensation or promote to the sponsor. For example, in a scenario with an 8% preferred return and a property that produces 10% in a year, investors are entitled to 8% as the tier one hurdle before the sponsor begins to participate in any split of the 2% excess free cash flow of the property. This is of course assuming that the property is producing returns above the 8% IRR threshold. But what if the property isn't?

Preferred returns not only have different rates, but also differ mechanically. Preferred returns can either be compounding or non-compounding. A compounding preferred return means that shortfalls are not simply accrued but are also compounded with interest at the preferred return rate. This protects investors from any losses on a time value of money basis, and protects investors in the event of cash flow distributions that are less than the preferred return. Non-compounding preferred returns, on the other hand, carry no penalty to sponsors in the event the property and sponsor do not meet the preferred return distributions.

Another mechanical difference in preferred returns structures is whether they incorporate a return of invested capital to LPs. Here, passive investors are entitled to their preferred return as well as 100% of their original investment prior to any profit sharing with the sponsor. This type of preferred return provides additional protection to investors since they would not pay any performance compensation to the sponsor until after they had received back their original investment, as well as whatever the preferred return rate is for the deal. Once a preferred return and any of its mechanics are satisfied, then the sponsor begins to receive performance compensation or the promote.

Cash on Cash Returns

Cash on cash, also called cash yield, relates only to the total return from forecasted cash flows from the property, as opposed to the order in which they are paid to LPs and GPs. A cash on cash calculation is a return metric that measures the return on the actual cash invested, excluding leverage. Annual cash on cash is measured year over year by dividing the annual free cash flow by the total capital invested overall. Investors should also consider the average of these values to get their total average cash on cash for the full cycle of the project.

Preferred Returns Implications on Cash Flows

Putting these mechanics together, let's say the average cash on cash for the hold period is 7%, while the preferred return is 8%. Especially in a low cash flow environment, having a lower cash on cash than the structured preferred return is not an immediate indicator that investors will not see considerable returns, especially if the preferred return is structured in an aligned manner. This is where the aforementioned compounding and return of capital mechanics of a preferred return comes into play.

The shortfalls between the average 7% cash on cash returns available for distribution and the 8% preferred return entitled to investors accrue and compound for the years the returns are short, yielding later returns for investors upon a capital event as payment for waiting for their returns. If also structured with a return of capital mechanic, the LPs investment and preferred return are largely protected if the proceeds from a capital event are high enough. The returns to investors upon a refinance or sale in a deal with this structure would include a 100% return of capital, the 8% preferred return, as well as any interest compounded from previously short distributions. So while a preferred return that is higher than the average cash on cash does not mean investors are guaranteed an 8% annual return, it also does not mean that investors will not be repaid for the preferred return if it is structured properly.

Overall, preferred returns do not directly equate to cash on cash returns for each distribution. Investors who are looking specifically for the cash flow of the asset should look at the average and annual cash on cash returns. Also note that for this example we have assumed that the preferred return tier one hurdle type is based on IRR, has a compounding preferred return, as well as a 100% return of investment, which is how Rulteus Capital Group structures its returns to investors. Investors should always clarify with sponsors how their waterfalls are structured to ensure how their expected distributions are being calculated. Furthermore, we would advise that investors are skeptical of investment opportunities that do not include preferred returns as this typically does not align incentives between investors and sponsors.

Daniel,

Would love to hear more about the opportunity. Feel free to send me a message to set something up.

Given the current capital markets and high interest rates, I wanted to share a quick breakdown of what owners should consider when doing loan assumptions as a strategy to get lower cost debt. 

While loan assumptions can potentially be leveraged for lower debt service, assumptions simultaneously impact risk factors for an investment. Investors must evaluate the trade-off of a competitive interest rate against its concurrent variances in price, interest rate, leverage, term, and interest only period to determine if it matches their business plan. Furthermore, each of these variables are affected differently in low vs high cost debt markets. Following the recent interest rate rises in capital markets, this article will give a full breakdown of loan assumptions but will focus on loan assumptions in a high debt cost market.

Loan Assumptions in High Debt Markets

As mentioned above, the primary considerations in a loan assumption scenario are the price, interest rate, leverage, term, and interest only period of the in-place debt.

Price - While it may be tempting to first consider the interest rate when looking at loan assumptions, its price implications are more important for the risk/return evaluation of the debt structuring for a deal. Purchase price is permanent, financing is temporary. Debt has the optionality to be refinanced, supplemented with mezzanine financing, or restructured with the lender. Purchase price, however, cannot be modified once a deal is acquired. Operators must consider if the lower interest rate provided by an assumption outweighs the stresses a higher purchase price enacts on return metrics for investors. Especially in a high debt cost market, sellers may feel (rightfully) entitled to an increase in purchase price by allowing the buyer to conduct a loan assumption of their lower rate debt.

Interest Rate - A lower interest rate on your debt means a lower debt service, which results in higher cash flow for the property. While higher free cash flow will boost IRR, it is not the only factor for returns. As alluded to above, the interest rate benefits provided by a loan assumption are inexorably tied to price considerations. Enhanced cash flow from lower debt service in exchange for a higher purchase price may still result in a net lower return. Returns may suffer from the now smaller delta between acquisition price and eventual sale price. This is especially true for value-add investment strategies, in which the majority of internal rate of return (IRR) for the property typically comes from sale as opposed to generated cash flow. Even if the lower interest rate and resulting debt service may lower the risk of the investment, other risk factors in the assumed debt must also be considered.

Leverage - Often used synonymously with risk, the leverage of the loan is the next consideration for an assumption. While leverage can typically be quasi-tailored for an investment's risk-return appetite when securing new financing, buyers are limited in their leveraging options in a loan assumption. In acquiring the existing senior debt on a property, operators inherit both the interest rate of the debt and the amount of the debt. Presuming that the acquisition property has appreciated since its last acquisition, the now higher valuation will result in lower leverage if the debt amount remains constant. Lower leverage provides less risk of default, but also limits an investment's return metrics as the rest of the acquisition price will be now filled with equity, the same equity that is expecting returns. Leverage can be increased by expanding the capital stack with mezzanine debt or preferred equity, but these added layers require higher payouts than senior debt, even in high debt cost markets. Furthermore, risk is added to common equity investors who are now even farther down the distribution waterfall. These risk factors are in the capital stack of the investment, but the loan assumer must also account for risk factors from the timing of the investment as well.

Term - The term of the loan is the source of timing risk for the execution of the business plan for an investment. For example, if at the time of assumption a seller is 8 years into a 10 year term loan, then the buyer now only has 2 years remaining before said loan comes to maturity. A short runway on the term of the loan stresses both a buyer’s business plan and exit options. In regards to business plan, a value-add buyer would have to renovate, rent increase, and stabilize an asset within the remaining term period in order to avoid a potentially catastrophic capital event during the asset repositioning. Even if the buyer can complete their business plan within the remaining term, they now are forced into a capital event in whatever the prevailing real estate market conditions are, with no option to extend the hold period without additional financing. The timing risk of an investment is also intertwined with the interest-only period of the assumed loan.

Interest Only Period - While the expiration of an interest only period will not force an operator into a capital event, the timing of the remaining interest-only period on the assumed loan will limit their ability to customize it to their business plan. As an example, let's say the seller financed a deal 2 years ago, with a 10 year term, and is looking to sell on assumption. The term remaining is 8 years. If the seller got 0 zero years of interest only, the loan started amortizing two years ago. The debt constant in this case is going to be high, which is going to be less attractive to a buyer, as they are going to have weaker cash flow. If instead the seller structured that same loan with 10 years of interest only, that would be more attractive to the buyer. The loan is not paid down at all so the new acquirers are getting the full loan amount, and they are getting interest only for the remainder of the loan term, allowing the buyer to drive both leverage and cash flows.