Passive Investor Series Part 9: Return on Capital VS Return of Capital

When investing in syndications, the returns received are one of the essential factors in deciding whether to invest. While there are many types of returns one should consider when looking at a deal (i.e. IRR, Equity Multiple, AAR, etc.), an investor must also know whether the potential investment is providing return on capital or return of capital.

This one word, really one letter to be exact, can make a huge difference on how and what returns you receive on the investment. For this reason, let's cover what they are, the differences between the two, and the pros and cons of each.

RETURN ON CAPITAL

The return on capital is your ability to receive a return on your investment based upon the invested capital. For example, if you invested $100,000 in a property that paid an 8% annual distribution then you will earn $8,000 of cash flow. The important factor with a return on capital is there is no reduction of your invested capital with each distribution. Therefore, in the next year, your 8% distribution will also be $8,000. The only way your invested capital reduces is if there is a capital event, such as a refinance or sale of the property..

RETURN OF CAPITAL

Return of capital, as its name implies, is the return of your capital with each distribution. For example, if you take the same $100,000 from above with an 8% annual distribution then the $8,000 of cash flow reduces your invested capital down to $92,000 ($100,000 - $8,000). Therefore, the following year, your 8% distribution is now $7,360 ($92,000 x 8%) and your invested capital $84,640. Capital events will also further reduce your invested capital.

PRO AND CONS

At this point, you may be asking yourself why would anyone want to choose the return of capital versus a return on capital?

PROS

Return on Capital
The pros of the return on capital is the fact your cash flow will be higher since your invested capital is not being reduced.

Return of Capital
With a return of capital, the capital that is being returned to you is not going to be subject to taxes. This is because these are not considered income or gains but a capital return.

CONS

Return on Capital
The distributions you receive from your investment will be subject to taxes.

Return of Capital
The reduction of your capital with distributions.

WHICH ONE IS BETTER?

There is not one that is better than the other and it depends largely on your investment goals. If you are looking for maximum tax benefits, then a return of capital may be the best route. If you are looking to maximize your investment and create steady cash flow, then a return on capital should be considered.

Most investors prefer the return on capital as the purpose of investing into a deal is for the income and capital gain of their investment.

No matter which one you choose, be sure to read the investor documents carefully to know whether the distributions you receive are a return on capital or return of capital. You will want to ensure the potential investment meets the type of returns you are looking for.