JF1989: Learn the Difference between Preferred & Cash On Cash Return | Syndication School with Theo Hicks
Theo explains in detail the difference between Preferred Return and Cash on Cash Return. At the end of this episode you will be able to communicate with your investors in a way that will make them comfortable enough to trust you as an expert GP. You will also walk away with examples on how Joe handles his deals and the creativity he utilizes between Series A and Series B investors.
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“Depending on how the math works out the class B investors are definitely not going to receive their entire preferred return for that year, and the class A investors depending on what % of the LP they make up, may also not get their full preferred return.” – Theo Hicks
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Theo Hicks: Hi, Best Ever listeners and welcome back to another edition of The Syndication School series, a free resource focused on the how-to’s of apartment syndications. As always, I’m your host, Theo Hicks. Each week, we air two podcast episodes, also released in video form on YouTube, that focus on a specific aspect of the apartment syndication investment strategy. For the majority of these episodes and series, we offer some free resource to you to download for free. These are PowerPoint presentation templates, Excel template calculators, PDF how-to guides, something that will accompany the episodes that will help you further your apartment syndication business. All of these free documents, as well as the past syndication school series episodes can be found at syndicationschool.com.
In this episode we are going to focus on the differences between preferred return and cash-on-cash return. So obviously, there are two different return factors that you are going to be presenting to your passive investors. It’s important for you to understand the differences between these two, so that if your passive investors were to ask you any questions on “Why is the preferred return 8%, but you’re telling me that my cash-on-cash return is 10%? How does that work?” Well, after listening to this episode, you will have an answer to provide them that makes sense in their eyes.
Of course, the way that the preferred return and the cash-on-cash return work is going to be based off of the types of offerings that you offer to your investors. In a previous syndication school series, we talked about the pros and cons, the differences between Class A and Class B investors. If you’re going to decide to offer two different structures to your passive investors, or you might just offer one different tier– so if you’re offering two, you’re gonna have different answers to offer to each of those investors, depending on which tier, which structure they’ve decided to invest in.
So first, some definitions. The preferred return is going to be the threshold return that is offered to the limited partners that is received before you, the general partner, receives any profits. If you structured the partnership such that the asset management fee that you charge is in a position behind the preferred return, then you don’t get paid at all until they make their preferred returns. You don’t get a part of the profits, nor do you get your asset management fee.
That’s one thing you can do to create a stronger alignment of interest between you and your investors by putting an asset management fee in second position, which we’ve talked about on the syndication school series in the past.
The cash-on-cash return is going to be the overall actual returns to the limited partners over the lifetime of the project. So those are the definitional differences, but it’d be better to explain it to your investors in terms of some example, because they can look up the definitions themselves. Just providing them with the definition isn’t necessarily answering their question because they want to know what that means to them in actual dollar amounts.
For example, for Joe’s deals they distribute returns on a monthly basis. So the preferred return is going to be prorated. So when we tell an investor that they’re going to make a 10% preferred return that’s going to be distributed monthly, that doesn’t mean that they’re going to get 10% each month, or 120% for the year. The preferred return is typically going to be in terms of an annual number.
Also, for Joe’s deals there’s the Class A and the Class of B structure. Based off of the way that deals are structured, Class A investors get their preferred return first, and then once all Class A investors have received their preferred return, then the Class B investors will receive their monthly return secondly. So if you just have Class A investors, then they’re the ones that get paid, and then once they get paid; you, the GP, which might be considered Class B, you then get paid. If you have the Class A and Class B structure, then you’re Class C and you get paid last.
So if you do have the Class A and the Class B structure, let’s say that one investor invested $100,000 as a Class A investor, another investor invested $100,000 as a Class B investor. In Joe’s deals, he offers a 10% preferred return to the Class A investors and a 7% preferred return to the Class B investors. Therefore, each year, the Class A investors will receive $10,000, which equates to $833.33 per month in distributions, assuming that number is met because B investor will get their 7% preferred return, which would be $7,000 per year, or $583.33 per month. So that’s just the preferred return portion.
So assuming the deal hits the projections, and assuming you projected at least a 10% preferred return to your Class A investors, and at least a 7% preferred return to your Class B investors, that is the distribution they’re going to get each month. So you’ve got the definition of preferred return, and then you can explain to them based off of a sample investment… If they’re a Class A investor, here’s how much money you’ll be distributed as a preferred return each month. As a Class B investor, here’s how much will be distributed to you each month. So that covers the preferred return portion.
So what about the cash-on-cash return? Is it going to be higher, lower, different than the preferred return? So first, finishing up the preferred return, they’re gonna want to know, well, is that guaranteed? Am I guaranteed to get that $800+ per month as a Class A investor or $580+ dollars per month as a Class B investor? Or are there situations where I will not receive that distribution each month? There’s actually two scenarios where the investors would not receive their monthly distribution.
The first scenario would be if the general partner projected a return for year one – maybe year two, but let’s just stick with year one – if you projected a return in year one that is less than whatever that preferred return is. So if you offer a 10% and a 7% to your passive investors, and that total preferred return equates to, let’s just say, $100,000 per year, but your year one projection is going to be $80,000 per year, and then maybe year two you get above $100,000 and you’re projecting $120,000 per year… Well, year one, depending on how the math works out, the Class B investors are definitely not going to receive their entire preferred return for that year. The Class A investors, depending on what percentage of the LP they make up, may also not get their full preferred return. But if it’s only off by that much, it’s likely that the Class A investors will see their full preferred return, especially since, at least for Joe’s deals, the Class A investors make up a smaller portion of the pot; so I think it’s a maximum of 25%. But the Class B investors get their full preferred return because the projected returns are less than the return needed to distribute all the preferred returns. That’s one scenario.
The second scenario would be if the return projections are equal to or greater than the preferred return. So projection-wise you should be able to distribute everything, but when the actual returns come in, it comes in at less than the preferred return. So continuing with our previous example, you need a 100k to hit the full preferred return distribution to your investors, just 100k. And then you projected $110,000, so $100,000 plus $10,000 leftover – we’ll talk about what to do with that 10k in a second – but in reality, you only are able to get $90,000. Then again, Class B is not going to hit that full preferred return.
So if that happens, well, the process will depend on how the partnership was structured in the PPM. So for Joe’s deals, for example, the difference between whatever the preferred return is supposed to be and whatever the actual return was, assuming it’s a negative number, assuming there’s a difference, then the preferred return would accrue and then be paid out in the future.
Now, some syndicators will have a structure where the preferred return accrues, other ones won’t. Some will have a structure where the preferred return will be paid out in the next year or next month, or whenever the cashflow supports the distribution, or it’ll accrue until the sale. So it really depends on the structure; you can be anywhere in between, and it’s really up to you. So you’re gonna want to let your investors know, “Okay, well, here’s what the preferred term is, here’s an example. But if we don’t hit that number, here’s what happens.”
So now let’s talk about the cash-on-cash return portion of this, and this is what Joe does for his deals. You’re going to approach this differently, but at some point, if you’ve structured a deal such that there’s a profit split– so if you’re just offering a preferred return, then the preferred return is going to be equal to the cash-on-cash return. So for Class A investors, for Joe’s deals, they do not participate in the upside. So the preferred return is equal to the cash-on-cash return. Class B, on the other hand, do participate in the upside, so the preferred return is not going to be equal to the cash-on-cash return. That’s why I said in the beginning, it’s different for Class A and Class B investors.
For Joe’s deals, in particular, every 12 months – so 12 months, 24 months, 36 months, etc. – they will reevaluate the performance of the deal. So after 12 months, they’ll take a look at the cashflow and see if the deal cash-flowed more than the preferred return. If it did, then that extra cashflow will be distributed in a one-time payment at the end of that year, based off of whatever that profit split structure is.
As I mentioned, for those deals, these types of structures, the Class A investors are not going to get a profit split. In return, they’re offered a higher preferred return that’s paid out first before the Class B investors get paid. Whereas Class B investors are offered a lower preferred return, and they do receive a profit split. So any of the profits that are determined at the end of the 12-month cycles will be split between the Class B investors as well as the general partners.
Now, there’s two cash-on-cash return metrics that are going to be important to your investors, and those are the ones that include the proceeds from sale and do not include the proceeds from sale. So for the Class A investors, these two cash-on-cash return metrics are going to be the same, because they are not participating in the upside, and therefore they’re not participating in the ongoing profit split, and they’re not participating in the profit split from the sales proceeds. So the preferred return is 10%, the annualized cash-on-cash return excluding profits from sale is 10%, and the average annual cash-on-cash return, including the profits from sale, is also 10%. So 10% across the board; pretty simple to explain the differences between the preferred return and the cash-on-cash return to Class A investors, because there is no difference; they’re going to be the same.
Class B is going to be a little bit different, again, because they are participating. So the preferred return and the two cash-on-cash return metrics – all three of those are going to be different, unless you’ve magically only hit the preferred return number, and then at sale there is no profit, there is no loss, it’s just even; which is not going to happen. So they’re going to be different, even if it’s just a few decimal points off.
Let’s do an example for the Class B. We’ve got a Class B investor who invests the $100,000 into an apartment syndication and they’re offered a 7% preferred return, and the predicted hold period is going to be five years. You honor the deal and you determine that the cash-on-cash return projections, excluding the profits from sale, is going to be an average of 8.2% each year. So year one, you’re assuming you’ll make 7% cash-on-cash return; year two, 7.4%; year three, 8.2%; year four 9.1%; year five, 9.4%. The average of that is 8.2%, therefore the average cash-on-cash return to Class B investors excluding the profits from sale is going to be 8.2%.
So we’ve got a 7% preferred return, assuming that projections aren’t hit. Assuming that it accrues, the preferred return is going to be 7%. Their cash-on-cash return excluding profit and sales is going to be 8.2%, so now we’ve already got a difference of 1.2%. Again, at the end of year one, when the deal’s analyzed, it’s determined “Okay, there is no profit to split, so there’s no extra distribution. Oh, end of year two, we determined that we can distribute an extra 0.4% investors to give them a total return of 7.4% for the year; 7% being the preferred return, 0.4% being the profit.” Those two combined are going to be the cash-on-cash return. Same for year three, year four and year five.
Now let’s say that the goal is to sell the deal the end of year five, because you may have this conversation upfront with them. The projected profits at sale is determined to be approximately at 59% of the Class B investors’ initial investment. So for year five, they’ve already received the 7% preferred return, they’ve received the 2.4% profit projected, so 9.4% cash-on-cash return excluding the sale that we mentioned before, plus the additional 59% that they’re going to get at the end of year five when the deal is sold. So the total return for year five is going to be 68.4%. So going back to the other cash flows of year one through four, of 7.4%, 8.2%, 9.1%… Now year five, including the profits on sale, is going to be 68.4%. You average those numbers and you get the average return of 20%, including the profits from the sale.
So again, 7% cash-on-cash return, excluding profits from sale, is 8.2% per year, and the cash-on-cash return, including the profits from sale, is going to be 20%. So a little bit more difficult, a little more complicated than just simply saying, “Oh Class A investors, it’s just 10% across the board.”
Now, logistically, how will this work? Well, from the investor’s perspective, month one through month 12 they’re going to receive, assuming projects are hit, that prorated 7%. So if they invested the $100,000, they’re going to get that $583.33 per month. Then at the end of those 12 months it was determined that there are not profits, so they’ll just get the $580+ distribution. Months 13 through 24 – same thing, prorate is 7%. At the end of year two it’s determined that the projections were hit, we can distribute that extra 0.4%, so they’ll get the same $583.33 plus 0.4%, so an extra $400 in that distribution, assuming they invested $100,000.
Same thing for year three, they get an extra 1.2%, so $1,200. End of the year four it’s gonna be 2.1%, so $2,100. End of year five it’s going to be 2.4%, so $2,400 plus the distribution from the sale.
Depending on how you structure it, you don’t have to wait until the end of 12 months; you can do it on a monthly basis. You can wait until the sale, you can really do whatever you want. But that is the explanation for the differences between the cash-on-cash returns and the preferred return… Keeping in mind that there are two cash-on-cash return metrics.
To quickly summarize– so this is what you can put into emails, is that the preferred return is going to be the threshold return that’s offered each month. It’s a percentage, and assuming that the projections are hit, you’re going to receive that percentage. If that percentage is not hit, then fill in the blank; it’ll accrue, or it won’t accrue.
The cash-on-cash return is a return metric that includes the preferred return plus the extra profits you receive. So if you don’t receive profits, the preferred return and the cash-on-cash returns are going to be the exact same. If you do participate in the profits, the cash-on-cash returns are going to be higher than the preferred return.
There’s gonna be one that excludes the profits from sales, so that’ll just be your yearly preferred return plus your yearly profit, and there’s one that includes a profit from sale, which is the same plus the additional split of the sales proceeds. So those are the differences between the cash-on-cash return and the preferred return in practical terms, with examples.
Until tomorrow, make sure you check out some of the other Syndication School series and episodes about the how-tos of apartment syndications and make sure you download those free documents we have available as well. All those are at syndicationschool.com. Thank you for listening and I will talk to you tomorrow.