How to Calculate the Preferred Return and IRR for Apartment Syndication Deals – Ask The Expert

One of my consulting clients asked me two questions about calculating the two return factors that are the most relevant to passive investors: preferred return and internal rate of return.

Questions #1: When a syndicator purchases an apartment complex, how can they determine what the preferred monthly return is going to be?

Questions #2: When a syndicator purchases an apartment complex, how can they determine what the profit is going to be that gives them the estimated IRR?

Theo Hicks, who is the key underwriter for my consulting program, provided answers to these two questions and here is what he said.

 

Question #1 – How to Calculate Preferred Return

The preferred return is a threshold return that limited partners are offered prior to the general partners receiving payment. If the preferred return is 8% paid out monthly, for example, the limited partners will receive the first portion of the monthly cash flow up to 8%.

To calculate the preferred return amount, multiply the total equity investment from limited partners by the preferred return percentage. If the preferred return is 8% and limited partners invested $1 million, the annual preferred return is $80,000 (0.08 * $1,000,000). Typically, profits above the preferred return are split between the general partners and limited partners.

The general partner sets the preferred return percentage based on the business plan, the goals of their limited partners, and what other general partners who are implementing similar business plans are offering.

When underwriting a deal, the average annualized cash flow should exceed the preferred return amount offered to investors so that you can distribute the preferred return.

 

Question #2 – How to Calculate Internal Rate of Return (IRR)

To calculate IRR, you need to know the amount and date of all payments to investors. Unlike cash-on-cash return and equity multiples, IRR takes into account the time value of money (i.e., $100 received today is worth more than $100 received in 5 years).

Typically, the IRR calculation includes the ongoing distributions plus profits at sale. If there is a refinance or supplemental loan, those proceeds are included in the IRR calculation.

When underwriting a deal, you set income and expense assumptions based on how the property is currently operating, market rates, and conversations with your expert property management company. The output of your underwriting is the projected ongoing cash flow and sales proceeds. IRR assumes that distributions are paid annually. A more accurate IRR metric is XIRR, which tracks real time distributions.

 

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