Advanced target Metrics Limited Partner in Syndication

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Advanced target Metrics Limited Partner in Syndication

Duke Giordano
Investor 路 Passiveadvantage.com 路 Member since 2019 路 164 posts 路 91 votes

Hey All,

Wanted to touch base on a few topics that are not typically discussed in relation to components of a RE syndication deal and how this impacts things from the standpoint of the LP in relation to such factors as risk profile, return etc.  I am trying to get a bit granular and would appreciate any input from experienced LP's and syndicators.  For the most part this is in relation to Multi-family, but i guess can be applied to other asset classes as well.  Thanks in advance for your time and insights.

1. Early LP Distributions: There are some syndicators who early on in a deal let the cash flow speak for itself in that cash flow is typically less early on in a deal, and then ramps up as business plan is implemented, and finally with Refi/Sale.  However, there are also other syndicators who raise extra capitol to pay investors in the beginning of the deal (in essence paying your own money back) and has the effect of more steady cash flow early on.  My questions is how does either of these structures impact the deal itself in relation to return/risk metrics if at all, and would you prefer one model vs the other?

2. Renovations/Cap Ex Budget: There are some sponsors who fund renovations with initial money raised as capitol/equity, and other sponsors who finance or take a bridge loan (less common Post-COVID) to fund renovations.  How does each of these models of funding renovations impact risk/return from the perspective of the LP and which one is there a preferred method to do so?

3. Post-COVID Reserves:  I am curious what sort of reserves an LP should be looking for in a syndication the Post-COVID era?  There are some reserves that may be required for agency (Fannie/Freddie) debt, and others the sponsor chooses to on their own raise to decrease risk for unforeseen circumstances.  I have see a few different metrics used for calculation of reserves such as dollar per door (such as maybe $500-1000 per unit/per year), versus setting aside 9-12 months of OpEx (Expenses and Debt), or a certain percentage of purchase price such as (1-5%).  I am curious what is the preferred structure of reserves to see in a syndication as an LP in this current climate from a syndicator?

4. Free Cash: When evaluating a deal risk profile do you look for a sponsor to have set aside "free cash", and what is the typical funding source of such (Capital/Equity raise vs Finance).  How does this free cash allocation relate to the above reserve questions one looks for?  Is it included or separate from the reserves calculation?

Thanks all, look forward to discussion.

Duke

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Arn CenedellaPro Member
Rental Property Investor 路 Greenville, SC 路 Member since 2008 路 786 posts 路 1k+ votes
5y

@Duke Giordano

Good questions.

There is another question in conjunction with your questions:

Is cash flow considered RETURN ON or RETURN OF capital?

Personally, I do not appreciate or support syndicators that use reserves to pay LP investors a certain cash flow - in essence just giving the LP investor his money back - and somehow trying to pass that off as a return. It鈥檚 not a return generated by the operation of the property. It鈥檚 misleading.

I would much prefer a syndicator be upfront and project cash flows as RETURN ON investment.

So I would much prefer to see honest cash flow projections as say:

Year 1 4% Year 2 5.5% Year 3 6.5% and say 7 to 10% in the years following

Then

Year 1 7% Year 2 7% Year 3 8% etc and only providing those returns as RETURN OF investment.

If a syndicator wants to do it this way and some investors may be fine with it, then the syndicator needs to be very clear about what he or she is doing.

[email protected]650-575-6114
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  • Arn CenedellaPro Member
    Rental Property Investor 路 Greenville, SC 路 Member since 2008 路 786 posts 路 1k+ votes
    5y

    @Duke Giordano

    Good questions.

    There is another question in conjunction with your questions:

    Is cash flow considered RETURN ON or RETURN OF capital?

    Personally, I do not appreciate or support syndicators that use reserves to pay LP investors a certain cash flow - in essence just giving the LP investor his money back - and somehow trying to pass that off as a return. It鈥檚 not a return generated by the operation of the property. It鈥檚 misleading.

    I would much prefer a syndicator be upfront and project cash flows as RETURN ON investment.

    So I would much prefer to see honest cash flow projections as say:

    Year 1 4% Year 2 5.5% Year 3 6.5% and say 7 to 10% in the years following

    Then

    Year 1 7% Year 2 7% Year 3 8% etc and only providing those returns as RETURN OF investment.

    If a syndicator wants to do it this way and some investors may be fine with it, then the syndicator needs to be very clear about what he or she is doing.

    [email protected]650-575-6114
    2Reply
  • Danny RandazzoPro Member
    Apartment Syndicator 路 Charleston, SC 路 Member since 2016 路 973 posts 路 728 votes
    5y

    @Duke Giordano @Dan Handford would be a good source for you insights to each of these questions

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  • Rick MartinPro Member
    Rental Property Investor 路 Redondo Beach, CA 路 Member since 2017 路 411 posts 路 477 votes
    5y

    @Duke Giordano all astute questions. I'll do my best to answer.

    1. Early LP Distributions: As Arn alluded to, investors are basically getting paid back with their own money, with the guise that they are earning a return. If the deal is presented as a value ad business plan, it seems highly unlikely you will be earning a 7 or 8% pref right out of the gate, so it could be a question of ethics, and how this might affect investor trust. It also gives them an unfair advantage when compared with those "doing it by the book." A return of capital does affect the investor's adjusted cost basis, and once the cost basis is reduced to zero, any subsequent return will be taxable as a capital gain. Some say that a return of capital has a negative effect on overall returns.

    2. Renovations/Cap-Ex Budget: If you are borrowing and upping your LTC (Loan to Cost), you are increasing your risk. You also need to be able to transition into long-term debt at the end of the bridge-term, and this creates more uncertainty, and therefore more risk. Raising equity has an inverse effect on returns and reduces risk. It is the same concept as buying a single-family. If you paid all cash, you would have no pressure to pay the mortgage, but your COC% would be much lower.

    3. Post-COVID Reserves: projected returns are going to be negatively impacted in either scenario. The "preferred equity" structure is becoming popular. Also, most syndicators are offsetting COVID with conservative underwriting for the next one to two years.( for example, higher economic vacancy, bad debt, higher exit cap).

    4. Free Cash: If I understand the question correctly, "free cash" would be the equivalent to a rainy day fund, and this would be raised, and included in the "operating reserves" line. This is separate from "Capex reserves" and deposits to "replacement reserves." As a rule of thumb, $1000/unit + one month's revenues, should be set aside for operating reserves. If the syndicator has set aside this much for their operating budget and has allocated $300/unit for replacement reserves, the deal should be considered well capitalized.

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  • Duke Giordano
    OP
    Investor 路 Passiveadvantage.com 路 Member since 2019 路 164 posts 路 91 votes
    5y

    Thanks for the thoughtful input all @Arn Cenedella, @Danny Randazzo, @Rick Martin, much appreciated.  Rick, as a FU so total reserves should be roughly in the range of $1500 per unit (operating reserves+replacement reserves)?

    As an LP mostly interested in upside, I am really not a big fan of the more popular duel LP (Class A/Preferred Equity and Class B) structure.  It is really like a second tier of debt, or extra debt if a deal is 75/25 LTC with 15% preferred equity its really like a 90/10 LTC from perspective of class B investor.  Thus, kicking cashflow down road for cash B, and increasing risk.  Wish more syndications would stick with traditional model.

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  • Christopher Nemlich
    Las Vegas, NV 路 Member since 2015 路 33 posts 路 9 votes
    5y

    @Rick Martin Could you explain #1 a bit further? How exactly have you seen syndicators doing this and how can it be identified prior to investment?

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  • Duke Giordano
    OP
    Investor 路 Passiveadvantage.com 路 Member since 2019 路 164 posts 路 91 votes
    5y

    @Christopher Nemlich, @Rick Martin

    Hey Chris,

    I will let Rick answer, but in my experience when sponsors used raised capitol to pay LP's it is not commonly divulged.  You can either try to add up the equity raised with the loan and subtract cost of property to see what the delta is.  The other option is just ask the sponsor, but some may not be so forthright on this.  Others may know another way to see if this tactic is taking place.

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  • Arn CenedellaPro Member
    Rental Property Investor 路 Greenville, SC 路 Member since 2008 路 786 posts 路 1k+ votes
    5y

    @Duke Giordano @Christopher Nemlich @Rick Martin

    Some operators will be upfront about this and they will say: Treating distributions as return OF capital is good because return OF is not a taxable event whereas return ON would be. Of course depreciation offsets taxable income to a high degree.

    I would also suggest investors review the proforma wherein the operator lays out net operating income and cash flow over time. Is the cash flow in years 1 and 2 enough to pay the stated return? If not, then operator is just giving your money back.

    In my experience, most operators will answer questions openly and honestly. Of course, the investor needs to know what questions to ask, which of course is a big reason BP exists. 馃榾

    [email protected]650-575-6114
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  • Greg Dickerson
    Developer 路 Charlottesville, VA 路 Member since 2018 路 4k+ posts 路 4k+ votes
    5y

     A sponsor raising surplus funds to pay investors during the reposition period is very common and the same as a developer building in an interest reserve. Many lenders will do this as well so nothing unethical unless someone is deliberately miss leading investors and showing this as profit somehow which can not be justified in the proforma. Again as long as this is properly handled and disclosed it鈥檚 the same as any other reserve fund you raise from investors. This does make the deal more expensive 

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  • Arn CenedellaPro Member
    Rental Property Investor 路 Greenville, SC 路 Member since 2008 路 786 posts 路 1k+ votes
    5y

    @Greg Dickerson

    Yes disclosure is key. And whatever any investor wants to do is up to them. 
    in my mind, reserves generally are to cover planned CapEx and protect the investors against UNFORESEEN expenses.
    So I see a big difference between reserves collected for Cap Ex and unanticipated expenses AND reserves collected simply to boost returns. 
    Lenders require reserves so that their debt service is covered in case property does not perform as projected. 
    In my mind, there is a huge difference between these items. 
    Reserves collected to pay an investor a cash flow are way different than reserves collected for other purposes. 
    Just my opinion, others are free to disagree. 
    I am not interested in someone collecting money from me simply to give it back. 
    But that鈥檚 just me. 
    Others can do what they like. 


    [email protected]650-575-6114
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  • Christopher Nemlich
    Las Vegas, NV 路 Member since 2015 路 33 posts 路 9 votes
    5y

    In the case that this is done, does that then assume that since a portion of your capital has been returned you are then entitled to a lesser total pref moving forward (I.e. same % but off a lower basis)?

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  • Rick MartinPro Member
    Rental Property Investor 路 Redondo Beach, CA 路 Member since 2017 路 411 posts 路 477 votes
    5y

    You could look at the proforma, and analyzed NOI those first couple of years. Is there enough to be paying out cash flow distributions to investors? At the end of the day, I am not sure it hurts you @Christopher Nemlich. If anything, it will create a more predictable cashflow. Is it right?, Ethical? That is subject to debate.

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  • Evan Polaski
    Cincinnati, OH 路 Member since 2020 路 4k+ posts 路 3k+ votes
    5y

    @Duke Giordano - as has been discussed, there are pros and cons to reserves.  More equity and reserves in a deal means less risk overall, but also lower returns, if all else is equal to a low reserve, high leverage deal.

    Overall, I think these are valid questions in assessing the risks of the deal, but from my perspective as an LP is doesn't matter. Every sponsor is making guesses as to what will happen in the future. And distributions are made based on what actually happens. When all is said and done, if the reserves are overfunded for any reason, when they are paid back to the LP there will be a tax effect. If they are returned upon sale, it will look like a larger gain on sale. If they are returned during operations: i.e. the COVID reserves are not viewed as needed, or the CAPEX is complete and was overfunded, those reserves are returned and will either reduce your capital account or look like a return on equity, but have an effect on the K-1.

    From a sponsor's perspective, regardless of the source of the capital being sent, it will effect the investor's overall return and move the needle as far as a waterfall is concerned.  

    Most sponsors operate somewhere within all of these: they may not reserve to fund distributions, but reserve for potential downsides, as is prudent in my opinion.  When those downsides are viewed as being less likely, or the capital is no longer needed, they will return it to the investor, typically per the waterfall structure, again in my view a prudent move.  

    Both parties are aligned in wanting to get the most money back to investors as soon as possible. The investor wants this because it boosts their return and lets them reallocate their money. The sponsor wants this because they will likely have a carried interest that yields them more money the higher return they can generate. The return is commonly measured by IRR, and the earlier money gets back the investors, the higher the IRR.

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  • Greg Dickerson
    Developer 路 Charlottesville, VA 路 Member since 2018 路 4k+ posts 路 4k+ votes
    5y
    Originally posted by @Evan Polaski:

    @Duke Giordano - as has been discussed, there are pros and cons to reserves.  More equity and reserves in a deal means less risk overall, but also lower returns, if all else is equal to a low reserve, high leverage deal.

    Overall, I think these are valid questions in assessing the risks of the deal, but from my perspective as an LP is doesn't matter. Every sponsor is making guesses as to what will happen in the future. And distributions are made based on what actually happens. When all is said and done, if the reserves are overfunded for any reason, when they are paid back to the LP there will be a tax effect. If they are returned upon sale, it will look like a larger gain on sale. If they are returned during operations: i.e. the COVID reserves are not viewed as needed, or the CAPEX is complete and was overfunded, those reserves are returned and will either reduce your capital account or look like a return on equity, but have an effect on the K-1.

    From a sponsor's perspective, regardless of the source of the capital being sent, it will effect the investor's overall return and move the needle as far as a waterfall is concerned.  

    Most sponsors operate somewhere within all of these: they may not reserve to fund distributions, but reserve for potential downsides, as is prudent in my opinion.  When those downsides are viewed as being less likely, or the capital is no longer needed, they will return it to the investor, typically per the waterfall structure, again in my view a prudent move.  

    Both parties are aligned in wanting to get the most money back to investors as soon as possible. The investor wants this because it boosts their return and lets them reallocate their money. The sponsor wants this because they will likely have a carried interest that yields them more money the higher return they can generate. The return is commonly measured by IRR, and the earlier money gets back the investors, the higher the IRR.

    Return of capital is not a taxable event.

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  • Evan Polaski
    Cincinnati, OH 路 Member since 2020 路 4k+ posts 路 3k+ votes
    5y

    @Greg Dickerson - my understanding, which I am not a CPA, is that while a return of capital may not have a taxable effect this year, it does reduce your capital balance on a K-1 resulting in a larger capital gain upon disposition.

    But you are correct, my wording was not entirely clear.

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  • Greg Dickerson
    Developer 路 Charlottesville, VA 路 Member since 2018 路 4k+ posts 路 4k+ votes
    5y
    Originally posted by @Arn Cenedella:

    @Greg Dickerson

    Yes disclosure is key. And whatever any investor wants to do is up to them. 
    in my mind, reserves generally are to cover planned CapEx and protect the investors against UNFORESEEN expenses.
    So I see a big difference between reserves collected for Cap Ex and unanticipated expenses AND reserves collected simply to boost returns. 
    Lenders require reserves so that their debt service is covered in case property does not perform as projected. 
    In my mind, there is a huge difference between these items. 
    Reserves collected to pay an investor a cash flow are way different than reserves collected for other purposes. 
    Just my opinion, others are free to disagree. 
    I am not interested in someone collecting money from me simply to give it back. 
    But that鈥檚 just me. 
    Others can do what they like. 


    I understand how you are viewing this. It's a common misconception. This structure is not akin to a Ponzi scheme it is simply building in a reserve to pay interest. Very common practice in commercial real estate and development. It's actually the prudent way to do things. There is no difference between building this in up front and accruing interest until the capital event. At the end of the day you are investing for a return. It dosen't matter how that return is paid as long as it's legal and your equity is preserved. If you were paying yourself with your own investment your principle and equity would be reducing. Thats not what an interest reserve is. 

    As for cash reserves for lender requirements that comes from the investor equity as well so its essentially the same thing.

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  • Scott Ratner
    Member since 2020 路 25 posts 路 6 votes
    5y

    Hi. Wanted to add my two cents. Read a book recently about passive investing and it had a lot of GREAT info. Name is THE HANDS OFF INVESTOR by Brian Burke. Brian is a long time syndicator and someone that I trust. Give the book a try. Hope this helps.

    1Reply
  • Arn CenedellaPro Member
    Rental Property Investor 路 Greenville, SC 路 Member since 2008 路 786 posts 路 1k+ votes
    5y

    @Evan Polaski

    Insightful comments. Thank you.

    The interesting thing about investing is that rational individual investors can have different perspectives on how they look at investment issues. I love the brain storming and discussion. And the really good thing is each investor has the freedom and power to invest in a way that makes sense to them. At the end of the day, that鈥檚 all that counts. I understand differing valid perspectives can exist at the same time.

    [email protected]650-575-6114
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