Syndication: How Valuable is the Time Value of Money?

Question

Hello everyone,

I'm trying to get a sense for just how valuable tax deferment through depreciation is to the multifamily passive investor. Suppose passive investor Isabel invests 100k in a syndication. The syndication pays a 10% pref and has a hold period of 5 years, and imagine she's in a 25% tax bracket. Her cash flows would look like this.

Year 0) -100k (-100k from principle investment)

1) 7.5k = (10k from cash flow - 2.5k from taxes)

2) 7.5k = (10k from cash flow - 2.5k from taxes)

3) 7.5k = (10k from cash flow - 2.5k from taxes)

4) 7.5k = (10k from cash flow - 2.5k from taxes)

5) 125.5k = (100k from return of principle + 30k from equity - 4.5k from 15% capital gains)

Total Return: 55.5k

IRR: 10.4%

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Now suppose she uses depreciation, and is able to depreciate all of her cashflow. She is not using a 1031 on sale, so she will pay full recapture. Now her cash flows look like this.

Year 0) -100k (-100k from principle investment)

1) 10k = (10k from cash flow, 2.5k depreciated)

2) 10k = (10k from cash flow, 2.5k depreciated)

3) 10k = (10k from cash flow, 2.5k depreciated)

4) 10k = (10k from cash flow, 2.5k depreciated)

5) 115.5k = (100k from return of principle + 30k from equity - 4.5k from 15% capital gains - 10k paid as recapture)

Total Return: 55.5k

or if she reinvests that extra 2.5k every year at 10%

Total Return: 56.6k

IRR: 10.8%

Isabel only sees an improvement of 0.4% to her IRR or an extra 1.6k if she invests the extra cashflow. And if the hold period is doubled to 10 years, and the equity return is doubled to 60k. Her IRRs  change to 10.2% and 11.1%, or a 0.9% improvement, and she gets an 11.4k difference in total return.

Now that's not zero, but it seems like a small bonus at best. Would Isabel be right to consider her investments in a syndication this way, or is there more to the picture?

Bryan Hancock · Answer

Most syndication investments are driven largely by the upside the sponsor can produce. The next most important driver of financial return is cash flows. Depreciation and the tax shields generated are distant third or fourth considerations and are unlikely to move the needle much so passive investors would be wise to pay less attention to them. A lot of the tax reforms in the past 30 or 40 years have eliminated benefits that used to be present for passive investments like this.

Note that I didn't review your math so it may or may not be correct. In general tax savings probably shouldn't matter much. What you should be optimizing is your after-tax return net of tax savings and not tax savings exclusively.

Note that I didn't review your math so it may or may not be correct.  In general tax savings probably shouldn't matter much.  What you should be optimizing is your after-tax return net of tax savings and not tax savings exclusively.

Roni E. · Answer

While the tax benefit is good. The investment should be looked at what is my risk? What is my cash on cash return? What is my realistic IRR? I think looking at it this is bit of manipulation.

Wayne Brooks · Answer

@Shafi Noss One thing to remember, the inherent flaw in the IRR calculation is that it Assumes yearly cash flows are reinvested and obtain the same annual yield as the resulting yield.  Higher upfront returns tend to distort the calculated yield if the annual cash flows can’t be reinvested at the same rate.

Shafi Noss · Answer

@Basit Siddiqi

Basit, the example assumes a 100k principle investment, not a 100k taxable income.

Basit Siddiqi · Answer

@Shafi NossYour analysis does not necessarily make sense.Distributions from a partnership does not necessarily mean it is taxable. You report income from a partnership based on your profit / loss % in the partnership and how much profit/loss the partnership reported.Regarding the 10% preferred - syndication normally don't distribute based on 10% of taxable income; they do it based on book income or cash-flow.

Todd Dexheimer · Answer

With modeling depreciation, you can typically wipe out all gains and then some. So they maybe received $10k, but show on their taxes a loss of $8k. Now you have $18k extra to invest each year. Also, you are adding the interest wrong. You have to take the amount saved ($2500 in your case, $18,000 in my case) and multiply by 10%, then by the years invested. So the $2,500 that you save in year 1 is invested for 4 additional years, equaling $1,000, then $250 for 3 years, 2 years and 1 year. Total is $2500.

Everyone's tax situation is different, so when modeling IRR we do not take into consideration tax consequences.

Shafi Noss · Answer

I agree with you Roni, that those are the most important criteria. I wrote the example like this to set everything else aside. This way it's easier to look at just the tax part of it.

Jaysen, while that may be true for higher income investors, remember that recaptured depreciation is taxed at the same rate as income, but capped at 25%. High income investors benefit from this cap, but since Isabel is already in the 25% tax bracket, she doesn't save any money on recapture.

As for cost segregation, it's not forgotten. If she's able to depreciate 50k year one with cost seg, only 10k is needed each year and the rest is carried forward.

Jaysen Medhurst · Answer

I'm not really following your examples, but here are my initial thoughts.

By shifting profit from cash flow to capital gains you lower the taxes, @Shafi Noss. Cash flow is taxed as ordinary income (no FICA, though). In your example, that rate could be as high as 35%.

Your example also doesn't seem to account for cost segregation. This is done on nearly every large syndication and can pull forward 30-50% of initial investment as depreciation in the first few years. So $30-50k of depreciation, instead of the $10k you cite. The could essentially negate all cash flow for tax purposes.

Syndication: How Valuable is the Time Value of Money?

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