How’s your first week of 2021? I hope it’s better than 2020 J
For me, I attended a lot of conferences, listened to a lot of podcasts and absorbed Information like a sponge: What are the experts talking about? What might be the opportunities in 2021? What we need to stay away? Hopefully next week I can give you a short summary.
Today I am going to talk about a common “pitfall” in real estate syndication. As a passive investor, do you know the difference between “return on capital” and “return of capital”? Let’s use a simple example to illustrate the difference.
Let’s say you invest $100,000 into a deal, and the syndicator claims the “cash on cash return” is 10%. So the first year you collect $10,000. Simple, right? Question is, what’s your investment balance after the $10,000 distribution at the end of year 1?
If $10,000 is considered to be “return of capital”, you are not getting any return for your investment in year 1, you are simply getting your money back. Your balance is now $90,000.
If $10,000 is considered to be “return on capital”, your investment is still $100,000.
You might think as long as I am getting $10,000 every year, why do I care whether it’s “return of capital” or “return on capital”? The big difference is in year 5 when the property is sold. Usually the distribution waterfall in year 5 is as follows: pay LP preferred return à return remaining capital to LP à what’s left is then split between LP and GP as agreed, say 70/30.
Let’s say in year 5, after the property is sold and all the expenses are paid, we are left with X dollar.
If $10,000/year distribution is considered “return of capital”, then in year 5, you will get $10,000 (this is the distribution for year 5) + $50,000 (as GP already returned $50,000 capital to you) + 70%*(X-$10,000-$50,000). After you get paid, the GP is paid 30%*(X-$10,000-$50,000).
If $10,000/year distribution is considered “return on capital”, then in year 5, you will get $10,000 + $100,000 (your original capital) + 70%*(X-$10,000-$100,000). After you get paid, the GP is paid 30%*(X-$10,000-$100,000).
Now open the PPM and if you find statement like “all the cash distribution is considered return of capital”, at the same time, you also see the syndicator calls 10% “cash on cash return” (remember, this is not return on your investment, s/he is simply returning your own money back!), s/he is either trying to mislead you, or at best s/he is incompetent to tell the differences. Run away from these syndicators, as fast as you can!
Invest with Confidence.
Yan Yan
Sharpe Investor Group www.sharpeinvestorgroup.com
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