How to pay investors in 1st few months of value-add syndication?

[Dave DeMink]

Hello, BP community - 

First-time poster here, and appreciate your guidance on the below question.

I am curious about how we should be thinking about paying investors during the first few months of a value-add syndication when they have a preferred return (8% in this case), but the property will not be returning 8% until we stabilize rents and get them to market rates.  The current return is more like 6%, an after stabilization, more in the 10-11% range.

Any feedback on how we should be thinking about this would be helpful

Thank you
Dave

[Brian Burke]

I've noticed a trend lately where it seems that a lot of people got confused as to what a preferred return actually is.  Some people (investors and sponsors alike) think that a preferred return is a guaranteed payment--that the money must be paid on a schedule, similar to a loan payment.  That's just not what it is.  A preferred return means that the investor is in a preferred position, in other words, they get priority on the cash flow.  Until the preferred return hurdle is met, investors get 100% of whatever is distributed.  If the preferred return hurdle is 8% and the sponsor pays out 4% in the first year (not at all uncommon in a value-add scenario), the other 4% carries over to the next year and beyond.  For example, let's say that in year 2 the property throws off enough cash flow to pay the investors 8%--the investor gets all of it.  If in year 3 the property throws off enough cash to pay 12%, the investor gets all of it, because the investor is owed 8% for their preferred return, plus the 4% shortfall from year 1.  If in year 4 the property throws off 12% again, the investors get 8% and the remaining 4% drops down to the split tier(s).

The odd and disturbing trend I'm seeing a lot lately is sponsors raising additional capital and making cash flow distributions equivalent to the preferred return hurdle regardless of the performance of the real estate.  The reason I say that it's odd is it is just like saying, "give me $100,000.  I'll invest $85,000 of it in real estate, and I'll give you the remaining $15,000 back in quarterly installments over the first 2-3 years."  Uh, no thanks, I could invest $85,000 with you instead and keep my $15K.

Why would sponsors do this?  I'm not sure, you'd have to ask those that use this practice.  My guess is it is a marketing strategy--a way of attracting capital because you can tell your investor that they will "make" 8% on their money.  I think this is a reason because I had one sponsor ask me, "you don't do that?  How do you raise any money?"  Ugh.

Perhaps some sponsors do it because they don't know how to accrue a preferred return properly, so if they just make the distributions they don't have to track it.  I believe this is a reason because I see so many syndicators make posts on BP about preferred returns that are just wrong.  

In the case of either of these two reasons, as long as it's all disclosed to the investors, no harm, no foul.  But are they disclosing it?  I see so many offerings from sponsors that don't include a sources and uses of funds table.  The investors truly have no idea where the money is going.  Not good.

I suspect that there are also sponsors out there that do this to mask the true performance, obscuring the actual results from unsuspecting investors that don't know any better.  These investors confuse distributions with performance and think that as long as they are getting their distributions, everything is going just fine.  Meanwhile, the property could be in deep trouble and the entity could eventually run out of cash.  Hopefully this isn't happening out there--but I am pretty certain it is from what I've heard from investors that have called me to share their horror stories.

One consideration to not lose sight of is the overall return on the investment is a function of the amount of money raised and the amount of money returned.  This means that raising additional capital for the purposes of distributing it back actually lowers the rate of return for the investment overall.  More dollars in for the same profit out.  So while perhaps the instant gratification of an 8% distribution is nice, it comes at a cost in the long term.