Does Raising Equity for Reserves Artificially Increase Cash on Cash Return?
Investor · Member since 2018 · 259 posts · 74 votes
Does Raising Equity for Reserves Artificially Increase Cash on Cash Return?
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Investor · Asheville, NC · Member since 2023 · 16 posts · 19 votes
2y@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!
12 Replies
- Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes3y
@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.
7e investments53 Reviews - Investor · Member since 2018 · 259 posts · 74 votes3y
Does not sound right in what sense? I'm pretty sure the math is right. I've checked several examples. You have a good point about the IRR, but I still think any investor also considers cash flow and cash on cash return. Not to mention this also allows for an increased "preferred return" which might make one investment look artificially more attractive than another.
- Investor · MN · Member since 2021 · 19 posts · 25 votes3y
Kim, if they have TI and leasing costs in as part of the raise amount I am guessing there is vacancy at the building or they are expecting tenant turnover.
By raising for it on the front end they are preserving any positive cash flow or pref for the property, if it isn't part of the raise amount they would need to allocate a larger portion of the positive cash flow towards building up the balance for those inevitable costs.. which in turn would any pref or CoC for while. Depending on the size of the project this could be years.
The fact that they are preparing for these costs and accounting for them before the deal is even purchased is a good thing in my mind.
- Investor · Member since 2018 · 259 posts · 74 votes3y
Quote from @Zach Alms:
Kim, if they have TI and leasing costs in as part of the raise amount I am guessing there is vacancy at the building or they are expecting tenant turnover.
By raising for it on the front end they are preserving any positive cash flow or pref for the property, if it isn't part of the raise amount they would need to allocate a larger portion of the positive cash flow towards building up the balance for those inevitable costs.. which in turn would any pref or CoC for while. Depending on the size of the project this could be years.
The fact that they are preparing for these costs and accounting for them before the deal is even purchased is a good thing in my mind.
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.
- Investor · Member since 2018 · 259 posts · 74 votes3y
Quote from @Zach Alms:
Kim, if they have TI and leasing costs in as part of the raise amount I am guessing there is vacancy at the building or they are expecting tenant turnover.
By raising for it on the front end they are preserving any positive cash flow or pref for the property, if it isn't part of the raise amount they would need to allocate a larger portion of the positive cash flow towards building up the balance for those inevitable costs.. which in turn would any pref or CoC for while. Depending on the size of the project this could be years.
The fact that they are preparing for these costs and accounting for them before the deal is even purchased is a good thing in my mind.
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.
- Lender · Nationwide · Member since 2018 · 571 posts · 310 votes3y
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.
- Developer · Charleston, SC · Member since 2015 · 100 posts · 91 votes3y
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.
- 3yIan IppolitoBusiness MemberInvestor · Tampa, FL · Member since 2015 · 1k+ posts · 1k+ votesI agree that this "accounting technique" is very distorting (and artificially boosts the return versus a sponsor that's isn't doing this).
Quote from @Kim Hopkins:
Quote from @Zach Alms:
Kim, if they have TI and leasing costs in as part of the raise amount I am guessing there is vacancy at the building or they are expecting tenant turnover.
By raising for it on the front end they are preserving any positive cash flow or pref for the property, if it isn't part of the raise amount they would need to allocate a larger portion of the positive cash flow towards building up the balance for those inevitable costs.. which in turn would any pref or CoC for while. Depending on the size of the project this could be years.
The fact that they are preparing for these costs and accounting for them before the deal is even purchased is a good thing in my mind.
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.
And most sponsors don't do this...but enough do that I always dig into the pro forma to look (and then take it into account when doing comparisons).
The Real Estate Crowdfunding Review - Cincinnati, OH · Member since 2020 · 4k+ posts · 3k+ votes3y
@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.
- Investor · Fairfax, VA · Member since 2015 · 1k+ posts · 801 votes3y
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.
- Investor · Asheville, NC · Member since 2023 · 16 posts · 19 votes2y
@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!
- Investor · Member since 2018 · 259 posts · 74 votes2y
Quote from @Andrew Davis:
@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!
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.
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