Does Raising Equity for Reserves Artificially Increase Cash on Cash Return?

Question

I'm looking at a passive real estate investment where part of their equity raise is for Tenant Improvement and Leasing Commission (TI and LC) reserves.

When they calculate their annual cash flow, they do not include the annual estimated TI & LC since it was part of the equity raise and is in reserves.

This increases their annual cash flow since they no longer have TI&LC as a line item.

But more importantly, it can also increase their Cash on Cash (COC) return.

(If you just raised Equity without TI&LC, and you have Cash Flow (CF), then your COC = CF/Equity. If you raise Equity + TI&LC where TI&LC is your TI&LC for the first year for example, then the new cash on cash for that year is COC = (CF+ TI&LC)/(Equity + TI&LC). If you just play with the numbers and don't raise too much, you can increase your COC this way).

So raising additional money for TI&LC or whatever can increase your COC return. But are you really making a better return? Aren't they just taking more of your capital and giving some back slowly from reserves without it actually having anything to do with the return of the property?

Confused.

Andrew Davis · Answer

@Kim Hopkins A. long time no see - hope you're well!

Paying distributions out of raised equity is fairly common among sponsors, especially in recent years as the early years of acquisitions are often very cash constrained (see years 1-2/3 DSCR).

While some investors like the reliable/higher cashflows, in my opinion, equity raised for the express purpose of paying higher cashflows in the early years is a disservice to the investor, as it increases the risk in the deal, and dilutes the overall return.

Just my $.02!

Kim Hopkins · Answer

Hey Andrew! Hope you're doing well!

Yes I totally agree. And it increases the cash on cash return totally artificially. That return will only last as long as the reserves are available unless they have truly increased cash flow to the same level as they were paying from the reserves. But the problem is the reserves are often for recurring expenses such as tenant improvements that will turn every time a lease turns.

It's actually made me completely dubious about passively investing. I just can't trust the numbers. We lucked out on this one that we had access to their actual spreadsheet and underwriting but otherwise it's usually impossible to tell what kinds of things like this are being baked in to the pro forma.

Shafi Noss · Answer

Yes I think your analysis is correct, the investors are not making better returns.

All else equal, raising extra money decreases CoC and lower expenses increases CoC. In this case the increase outweighs the decrease and CoC is artificially inflated as you point out.

Even though I think it's a poor metric for most real estate investments, IRR does catch this trick and takes some damage. I suspect the increase in CoC would be large and the decrease in IRR would be small so it would still fool most LPs.

Chris Seveney · Answer

@Kim Hopkins

That does not sound right at all but also this is why CoC is typically not an accurate basis for determining your return.

There are many metrics but we like to use IRR and have the returns bifurcated based on hold and exit to see if all profits come at exit and what numbers look like.

John McKee · Answer

Sounds like a red flag to me.  I just recently looked at a deal and asked when the money was being returned.  They said it's not, but I get paid out over 7 years.  So basically they are paying me my own money back over time.

Evan Polaski · Answer

@Kim Hopkins, it depends on what you period of time you are talking about for CoC, typically people are looking at CoC two ways: with sale proceeds and excluding sale proceeds.

What you are talking about will help the CoC excluding sale proceeds and hinder the CoC including sale proceeds.  IRR is harder to determine, because while raising more money does dilute the share of profit to each individual investor, by allowing for a higher upfront payout in the first couple years, you could be offsetting that dilution (this would be case by case).

Ultimately, there are a lot of ways to financially engineer the returns in a deal.  They all have their potential risks. But the fact of the matter is, all else being equal: more equity in the deal, regardless of what it is earmarked for, is safer.  Safer yields lower overall returns. Now, if the operator is just throwing the TI money away (a la landlords to Steve and Barry's), then that is another story.

Tim Bratz · Answer

I don't know if I would say it artificially increases returns, but I would say it creates a more predictable return for the investor. Whether it's paid out of reserves or out of cash flow, it equally adds to the cost basis. And if it's not needed, then it can go to reducing the cost basis. The one way it adversely affects the project, is that it is paying preferred returns on that undeployed capital.

Kim Hopkins · Answer

To add on to the above, it only makes sense if it is a one-time capex improvement. But these are recurring TI and leasing commissions. It's a multi-tenant property. This process happens continually throughout the entire hold period, not just an upfront one time expense.

Kim Hopkins · Answer

Zach, It might be a good thing but it completely distorts the cash flow and cash on cash return. Think about this way. If you're raising TI and LC for the first 5 years of costs and it's a 10-year hold, you're essentially giving back the investor their own money for the first 5 years, then you're out of money for those expenses. Your cash flow goes down and your cash on cash goes down at that point. The property didn't get any less productive from a return standpoint. It was just that you were giving the investors their own money back for 5 years. Another way to say it, the investor could have taken that money in reserves and invested it somewhere else instead of just making less cash flow on your deal.

It makes it so you absolutely cannot even look at the cash on cash return and cash flow for a passive investment deal because two deals could have the exact same actual performance but entirely different cash flows and cash on cash return based on how much one operator raises up front.

Does Raising Equity for Reserves Artificially Increase Cash on Cash Return?

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