JF2557: What Is the Difference Between a Preferred Return and a Cash-On-Cash Return? | Actively Passive Investing Show
In today’s episode of the Actively Passive Investing Show, Travis dives into passive investing and the difference between preferred returns and cash-on-cash returns. He walks us through this commonly asked question, gives examples of preferred and cash-on-cash returns, and tells us what terms we need to be clear on with the operators of these deals before investing.
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Travis Watts: Hey, everybody, and welcome to another episode of The Actively Passive Show. I’m your host, Travis Watts.
In today’s episode, what we’re talking about is being a passive investor in an apartment syndication, or I should say a real estate private placement of any sort, and what’s the difference between a preferred return and a cash-on-cash return. I want to dive a little bit deeper into this. This is a question that, working in investor relations for years, I’ve been asked this question, but also it seems like lately this has come up more and I just want to make sure that I address it. And now I have a video and a recording that I can share with people to go a little more in-depth.
When we’re looking at pro formas, when we’re looking at overviews and we’re seeing these different numbers on the page, you’re looking at IRRs and cap rates and projected returns and preferred returns and cash-on-cash returns, we’re going to hone in on cash-on-cash and preferred returns. I’m going to try my best to make this as simple and easy for you guys. But I do want to add some further color and clarity to this as well, I think it’s worth diving a bit deeper into.
Alright, let’s start with the high-level explanation. This would be my explanation of what a preferred return is. It’s essentially a threshold return paid to the limited partners in the deal before the general partners get their profits and their splits.
So to paint that picture, we have this apartment building, for example purposes. We collect money from our tenants in the form of their rent payments; we have X amount of dollars gross profit, and we have to pay our mortgage, we have to pay our property taxes, we have to pay maintenance and staff and personnel and these things. And then what we’re talking about is the cash flow after these items have been paid, are coming to the limited partners. And the preferred return basically is stating that that first amount of cash flow after paying those items I just discussed is going to the limited partners, before the people who put this deal together, the general partner or the general partners get their take.
Now let’s contrast that with a cash-on-cash return. My definition of a cash-on-cash return would be basically an overall projected return to the limited partners over the lifetime of the project. This is usually a variable number that changes from year to year.
Let’s dive into just a simple math example, because math is certainly not my strong point. So let’s assume that an operator distributes on a monthly basis; usually, in these private placements, in these syndications its monthly or its quarterly. But it could be different than that, but for simplicity here – monthly distributions. So we’re going to prorate the preferred return on a monthly basis.
So let’s take for example an investor who puts in $100,000 into a syndication deal, and they have a preferred return of 7% annualized. So they might receive $7,000 per year in this scenario, or $583.33 per month. And the reason that I say “might” is because there’s two scenarios where an investor wouldn’t receive the $583.33 per month. The first scenario would be that if the year number one projections for this particular deal are stated below the preferred return. So though there’s a 7% pref or preferred return in place, or sometimes the term coupon is used, if you ever see that term, the year one projections might be, let’s say, 6%, which would be one point below that.
Travis Watts: The second scenario that could come up is basically if the projected returns were at or above the preferred return, but the actual numbers that come in, the actual rents collected were below those numbers, then you would obviously have to take what you could get in that case and maybe not receive that preferred return.
In both of these cases, it really depends what the PPM states; and the PPM is an acronym for Private Placement Memorandum. It’s part of the legal docs that go along with investing in these types of investments.
So for example, the PPM might state that “The difference between the preferred return and the actual return might accrue and be paid out in the future if it happened to be below the pref.” Sometimes I’ve seen deals state that “If it’s below the preferred return, it doesn’t accrue, and that’s not owed to you at a later date.”
Oftentimes, what happens in one of these deals, just speaking from my own experience, and 30-40 of these deals as a limited partner, is that the general partnership will take a look and they’ll evaluate the numbers after, let’s say, a year after holding the property; or we’ll say every year. So on the 12th month mark the 24th month mark, the 36th month mark, they’re going to take a look at the actual numbers, and any cash flow, for example, that was above the preferred return might be distributed at that point as kind of a bonus distribution, so to speak. And again, how much and in what amounts is all determined in the PPM (the Private Placement Memorandum), the fees, the splits, etc. will be decided based off of that.
Alright, so honing in a little bit more on a cash-on-cash return. So it’s pretty common that you might see two different variations of a cash-on-cash return; two things might be listed in an overview or on a prospectus. You might see the return, excluding the profits at the end of the deal, in other words, the equity upside; and then you might see a cash-on-cash return that’s including the profits on the backside. Obviously, that’s going to be important to make sure that you understand and that you have a conversation with the operator about what you’re looking at, whether those are net or gross numbers, and what that means to you, the LP, in the deal.
So let me paint that example for you, the one that I mentioned previously about an investor who puts $100,000 into a deal, with a 7% preferred return, where the cash-on-cash could be variable from year to year. Let’s assume that this deal has a five-year hold. So maybe it’s a value-add play where they anticipate selling after about five years. And let’s say that the cash-on-cash projections that you’re looking at on the overview are as follows – year number one, 7%; year number two, 7.4%; year number three, 8.2%; year number four, 9.1%; year number five, 9.4%, increasing as you go year to year through the business plan, because hopefully, you’re able to raise rents throughout this process and the market rents are lifting due to inflation, things like this.
Travis Watts: If you take those numbers I just stated, the average would be 8.2%. So you might see that displayed, average cash-on-cash return, 8.2%. This would be obviously excluding any profits from the sale on the backend, assuming that the property went up in value over the five-year period. And let’s say that the projected equity on the backend of the deal, meaning the projected sale price would bring 59% of the investors’ original capital contributed to the deal. So that would equate to a year number five return of 68.4%. Because you’d take the 59% equity upside plus the cash flow throughout that year, which we said was 9.4%; you’re just adding those together. That also means that the average, year number one through year number five annualized return, including the profits at the backend, would be around 20%. So that’s cash-on-cash, but remember that the preferred return never changed. It remained 7% in this example, years one through five, and that’s often what’s paid out on a monthly basis pro rata. Again, sometimes with these, quote unquote, “bonus payments” coming in at the end of the 12th month and 24 and 36; that really depends on the operator, the PPM, and how that’s decided.
So going back really quick to this year number one through five cash-on-cash projections that we talked about – if the deal went perfectly to plan, 100%, this is how that would look then. Year number one, there would be no additional distribution, because it was a 7% projected return, with a 7% preferred return. Year number two would have a 0.4% extra distribution at some point. Year number three would have an extra distribution of 1.2%. Year number four, an extra distribution of 2.1%, and so on.
Alright, so let’s do a really quick recap. The difference between the preferred return and the cash-on-cash return is essentially the profits. The preferred return will stay the same throughout the lifespan of the deal, and the cash-on-cash return is going to deviate, whether it’s above or below what the preferred return is on the deal. Hopefully, that makes a little more sense, and hopefully you have a little more clarity around the difference between the two. I like to use visuals when possible, on this particular episode. Because we’re on an audio podcast, I’m not able to.
If you like short and sweet little videos like this, then send me an email, leave me a comment so that I know to record more of these on the show. As you know the theme of this show, Actively Passive, is that we want to outline these active components, these active self-education aspects to being a passive investor.
My goal is simply to help as many passive investors as I possibly can, to make things simple and easy, and just to be a voice in the space. That was such an impactful change, moving from active investing in real estate to passive. Had I known I could be hands-off, I would have made a lot of changes a lot earlier. Being a limited partner in a syndication allows you to get cash flow from real estate, use leverage (meaning mortgages) on real estate; you get to reap tax advantages that are in the tax code with real estate, but you don’t have to worry about managing the tenants, managing the toilets, trying to spend your days off competing for properties. You simply let the experts do what they do best and you participate in their deals with them.
Thank you, guys, again for tuning in. Travis Watts, with The Actively Passive Show. We will see you next time.
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