Understanding Preferred Returns

As an investor, there are various ways you could put your money to work. When you’re in the world of private placements, you may have heard of preferred returns. These refer to the order in which profits from a project are distributed to investors. Preferred return indicates a contractual entitlement to distributions of profit. Those who were promised preferred returns are given priority when the distribution of profits happens. This is maintained until a predetermined threshold rate of return has been met.

Preferred returns are usually expressed as a percentage of return on an annual basis. For example, if in an agreement you were promised a preferred return of 8% for a $100,000 investment, then you would receive $8,000 ($100,000 x 0.08) in annual return if available from the net revenue.

As an investor, the rate of preferred return is a vital component in checking the health of a particular investment, as it reveals the intent of your partners in returning your money. When you have preferred returns, you’re given priority over the company’s income before the general shareholders. That means the people running the company should work hard enough to not only meet the promised preferred returns but also generate enough excess income to be profitable.

In short, the operators will be focused on reducing the time spent before you get your return on investment, to increase your overall return. This will ensure that your goals as an investor and the goals of those running the company are in sync, and no one is out to cut the other short. 

By the nature of preferred returns, it is indeed more advantageous to the one with the capital. Thus, when you’re offered an investment, it pays to look for this clause. An operator may choose not to offer preferred returns because doing so will delay their split of the profits. While this is acceptable, as an investor, you may see this as a misalignment of interest. Another reason why operators may not offer preferred returns is if they are not as well-capitalized and need the proceeds from the cash flow to fund their syndication operations.

Types of Preferred Returns

Now that we’ve talked about preferred returns, let’s discuss their types. 

The first is cumulative versus non-cumulative. When you’re tasked to review a private placement memorandum (PPM), you will want to make sure that you take note of whether it’s a cumulative preferred return. Cumulative preferred return is ideal because it will help protect your overall return and here’s why.

Remember our example earlier? Let’s say, you’re given a preferred return of 8% per annum. In a non-cumulative preferred return, if you do not receive your total preferred return for one year, then you lose the difference. Say, in year 1 you receive back 6% (rather than the 8% that was anticipated).  With a non-cumulative return, you forfeit the right of getting the difference after that year has elapsed. Every year the preferred return resets and does not carry forward.

A cumulative preferred return gives you the right to add the difference and roll it over to the next year. For example, if your preferred return was 8% and you only received 6% one year, then your preferred return the following year would increase to 10% (8% + 2%).

In the normal business cycle, cash flows are expected to increase year to year as operations begin to stabilize and become more profitable. Thus, while the promised return in percentage is fixed, the actual value of such will be bigger since the number where it’s computed from also gets bigger as the years pass. This can lead you to get a return on investment sooner.

As a reminder, always read your documents carefully to be aware of whether you are investing in projects with a cumulative preferred return. 

Another type of preferred return is the preferred return with catch-up. This setup is considered the second position in the waterfall distribution schedule. Here, once your share of the profit is achieved and is set aside, the operator receives all or most of the profits until the operator “catches up” and reaches the same portion of equity you received. This type of catchup provision allows the operator to receive its entire equity split as originally agreed by both parties. 

What Else To Know

Another aspect that you should know about concerning PPMs is the difference between Preferred Returns and Preferred Equity. To differentiate both, let’s go back to the life cycle of the investment. Assuming that funding is already secured, your investment can either be with a preferred return, preferred equity, or both. We discussed how preferred returns work.  When it comes to preferred returns, the actual return of your overall capital is not in the picture.

When you have preferred equity, you’re prioritized to get your returns during the hold period and also have a priority treatment to get back your initial capital when the asset is sold. 

So it is a good business practice to consider adding an equal amount of preferred equity and preferred returns in your portfolio for risk management purposes. Preferred returns help you with a steadier, consistent cash flow; while as a preferred equity investor, you would receive your specified return and your initial capital back before any of the other investors.

When Do Preferred Returns Go Away?

Preferred returns are often calculated based on how much capital you contributed times the interest promised. However, there are distribution structures where your payouts are deducted from your capital. Thus, every payment you receive means a return from the capital you invested. This will also mean that since your returns are based on your unpaid capital, then it’s safe to assume that you will get smaller payments over time.

Some operators will say that this is a good idea because you are not paying taxes on the cash flow. However, since your preferred returns are based on unreturned capital contributions, your preferred returns will gradually diminish. Some operators prefer this structure because it allows them to achieve profitability quicker. 

As an investor, It’s generally better to choose preferred returns that are distributed from profits alone and not deducted from your initial capital so that your payouts will not be diminished. Typically you do not have to worry about the taxes right now anyway, since the depreciation each year should offset all the distributions you receive.

You also do not have to worry about the return in the capital, as preferred returns are not the most efficient way to get it back. Usually, to reduce your unreturned capital contributions or get it back completely, you need to go through a capital event such as a refinance or supplemental loan. Through these events, you would receive a portion of your initial capital back and this amount would reduce your unreturned capital contributions.

To make the above example less confusing, let’s pick up from our last scenario. You invested $100,000 and because of this, you will be getting an 8% preferred return rate (or $8,000 a year). Instead of deducting this amount from the initial capital, treat it as a dividend gain. In year three, when the operations have stabilized and the company is ripe and due for refinancing, that’s the time you can lobby to get a portion of your capital back. Your preferred return would then be based on the remaining unpaid capital. Thus, if during the said refinancing you were able to get around $40,000 back, then you will still be able to enjoy the fruits of the 8% preferred return rate on the $60,000.

With this example, it is important to note that even though your unreturned capital was reduced, this does not reduce your equity position in the overall deal. This amount is only used to calculate your preferred returns. However, some operators will reduce your equity position during a refinance or supplement loan, so be very diligent in reading the PPMs to make sure you know exactly what you are getting yourself into from the start.

Conclusion

Remember that just as with any venture you may get into, always protect your capital first. That’s the basic rule of risk management. Do not look so far ahead, especially to the potential gains, and overlook the red flags and risks that might be lurking in the PPM. Look at preferred returns as a powerful tool for you to protect your capital. It allows you to have preferential treatment in getting back your capital (and more) and eventually helps you grow your portfolio as a passive investor. By carefully choosing preferred returns, you reduce your risk when putting your money in private placements, since you are prioritized to receive the proceeds of all cash flows first.

Passive Investment in Multifamily Syndication vs. REIT – Which is Better?

Maybe you realize you want to invest passively in real estate, but you’re not sure which is better for you – to invest in multifamily (through a syndication) or an REIT.

This article helps you understand the difference between passive investment in multifamily versus passive investment in REIT, and aims to help you make an informed decision.

What is REIT?

A Real Estate Investment Trust, or REIT, is a company that has a wide range of revenue-generating properties. It involves a pool of passive shareholders, who receive subsequent dividends on their investment. A REIT can be any registered corporation or association that invests in real estate intending to generate revenue. It treats an investment as buying stock.

What is Multifamily Property Syndication?

A multifamily property refers to a residential property with more than one unit of accommodation, such as apartment buildings, townhouses, duplex properties, and condos. Syndication offers multiple individuals a wonderful passive investment opportunity that can generate substantial revenue over time.

Comparing REIT with Multifamily Property Investment

Now that you have a basic idea of these two types of passive real estate investment that you can venture into, let’s see which one is better for you. There are several factors on which you can weigh the two types of investments against each other.

Minimum Investment

When it comes to REITs, there is no cap on the minimum or maximum amount that you can invest, which makes it a much more flexible form of passive investment than multifamily properties. But there may be a rule where you can only buy shares in blocks of 10 or 50, and this is predetermined by the company you are buying real estate stocks from. This means that you can start from as low as $1,000.

On the other hand, when you invest in multifamily property, usually there is a minimum investment.  For example, some syndications require at least $50,000 as an initial investment. Plus, it may also ask for higher subsequent investments, which is not the case when you invest with REITs. This makes them much more flexible in terms of the minimum investment requirement.

Returns

One factor in which multifamily investments take the lead over REITs is the rate of return. With REITs, for the past five years the average annualized REIT return is under 6%, which is better than having it sit in a savings account, but could be better.

On the other hand, most multifamily property investments can bring you excellent yields of 9% and greater. Some properties have even brought wonderful returns of over 15%.

Liquidity

Liquidity refers to the ease with which an asset can be converted to cash, and while real estate investments don’t normally offer too much liquidity, you can actually experience it when you invest in REITs because you can trade them like a standard stock. If you have invested your capital recently but need to withdraw it for an emergency, you can do it quicker than you can with an investment directly in a multifamily property.

In a multifamily property syndication, your investment is locked in with the other investors, at least until the hold period is underway. However, there is a workaround to this problem and you can add it to your partnership or association agreement, which can help you get your capital amount back in a reasonable time.

Taxation

When it comes to taxes, whether you invest in REITs or a multifamily property syndication, there are depreciation benefits. With REITs, there is no way for you to defer the taxes on the profit that comes from the sale of your stocks. 

On the other hand, investing in multifamily properties allows you to defer the taxes if you reinvest in another project by taking advantage of the 1031 exchange.

Diversification of Portfolio

No matter what investment you make, your financial advisors may have always advised you to invest in a diversified portfolio or to “never put all your eggs in one basket”. This is a sound strategy that you can also apply to passive real estate investments. 

In REITs, your investment is distributed between an entire portfolio of properties, and their individual financial performance combines to bring you a safe and significant return.

On the contrary, with a multifamily syndication, your investment is tied to one multifamily property, and its financial performance constitutes the amount you get as a return on investment. But you can still diversify by investing with multiple syndicators, which is a viable option.

Risks

The risks also need to be assessed when you compare REITs with multifamily syndications. Since REITs are based on the buying and selling of stocks, the value of your investment may fall as the market value of the stocks goes down. This can present a risk.

Multifamily properties are typically a much lower risk, since they give you partial ownership in a physical asset, and the chances of the property value falling drastically are very unlikely.

Ease of Entry

The ease with which you can start investing in REITs or multifamily properties is also a deciding factor for some. As mentioned above, REITs have a smaller minimum investment requirement, and also don’t require any form of accreditation or validation about your financial condition or ability to invest.

However, when it comes to multifamily properties, depending on the route the company that you invest in is taking, they may require you to be accredited.  If so, they may ask you to provide an income statement that shows you have an annual income of at least $200,000 to be able to invest in a property. 

Ownership

When you invest in a REIT, you own stocks of the real estate portfolio that you invest in, which is somewhat abstract, and you don’t get your name on any property. This also means that you don’t reap the full benefits of the financial performance of that portfolio. 

On the other hand, investing in a single multifamily property allows you to attain ownership of the asset.  You have partial ownership of a real property that you can physically see.  You can see how the investment progresses as the company you’ve invested with implements their plan to improve profitability.  Your profits are tied to tangible things – improvements made, rents increased, occupancy rates, etc., which you can track.

Reachability

Reachability refers to the ease of access that you have with the people who manage your investment.  With REITs, it can be quite difficult for you to reach out to fund managers or investment consultants. Rather, you will be directed to a manager or representative.

This is an area where investing in multifamily properties excels, because you have direct access to the general partner or sponsor you’ve invested with – the person managing your investment.  You don’t have to go through some complicated process to speak to a real human, only to find out they can’t really do anything for you.  You can pick up the phone and call the general partner / sponsor or send them an email directly.

Key Takeaway

Both REITs and multifamily syndications allow you to make sound passive investments, and they are generally more attractive than other types of investment.  Do a little homework to determine what’s the best fit for you and then invest with a company you trust.

If you’re interested in high returns and great tax benefits, we would love to speak to you about investing passively in one of our upcoming multifamily property syndications. Contact us today to get started! 

Investing in Real Estate vs. the Stock Market

Investing in Real Estate vs. the Stock Market

Of the two types of investing, investing in stocks and shares seems on the surface to be more accessible to many than the world of property investment.

So, why would you consider investing in real estate?

Both types of investment have their pros and cons but the beauty of investing in property lies in the low risk, stability, and predictability of the investment.

When you add incredible tax advantages, hedge against inflation and control of investment to the list of positives then choosing to invest in tangible bricks and mortar over stocks and shares makes much more sense.

Let’s take a brief look at some of the pros and cons.

Stocks and Shares – Positives and Negatives

Negatives

1. Volatility

During a dip in the economy, you may be subject to the disappointment of diminishing funds as the profitability of the company drops.

Stock prices experience extreme short-term volatility, depending on the day’s events. Most smart traders do not react to these volatile market cycles but take a long term approach; however, the unpredictability of stocks can take its toll emotionally.

2. Risk

Stocks are volatile by nature because they depend greatly not only on the economy but also on the performance of a company and more importantly on the performance of the flawed individuals that run those companies.

If a company goes bankrupt then the money that you have invested in those stocks is completely dissolved.

This is a bigger risk than many are willing to take; many investors prefer to have their capital tied up in an investment over which they have a greater degree of control.

Negative publicity can also affect stock prices unexpectedly and in this day and age of instant news and of fake news, the volatility goes through the roof.

For example, on January 29, 2013, Audience ($ADNC), a voice processing company, found itself in muddy waters, literally, after a Twitter account named @MuddyWaters published a tweet about a false report in which the company was being investigated by the Department of Justice. The tweet set the company’s stock into a 25% drop. Muddy Water’s published a tweet after, clarifying the hoax.

3. Ambiguity

Accurate stock analysis calls for a great deal of study. Even many honest experts admit that they are barely scratching the surface when it comes to accurate in-depth analysis.

When you invest in stocks you effectively own a portion of the company that you are investing in. If that company manages to thrive then the value of your stock rises and you win. When the company struggles, you lose.

Positives

1. Passive Income

The entire process of investing in stocks can be automated.

Of course, when it comes to investing in property, you don’t have to be the one dealing with tenants’ problems. When you invest in a property deal that is syndicated by someone else then this means that your real estate investment income will effectively also be 100% passive. You are several steps removed from the day to day management of the property.

2. Liquidity

Buying and selling stock is a relatively straightforward and speedy process with low transaction costs. No tangible asset is being exchanged so the transaction is quick and inexpensive. The process of actually buying and selling stocks is obviously much more straightforward than buying and selling a property which often takes two or three months or more.

3. Diversification

Due to the relative ease of buying and selling stocks, it stands to reason that it would also be fairly simple to spread your capital across different stocks. This is a way to combat the volatility of the stock market where the prices of individual stocks fluctuate daily. Clearly, it would take a much greater investment of capital to diversify your real estate portfolio in the same way.

Real Estate – Positives and Negatives

Real estate is a tangible asset and as such for many investors, feels more real. A great appeal of this type of investment is its stability.

For many millions of people, this kind of investment has generated consistent wealth and long-term appreciation.

Real estate investment provides a very consistent and stable rental income. Having a home is a vital necessity for all people, and as a result, rental investors are relatively protected even during economic downturns.

Negatives

1. Lack of liquidity

With property, you can’t just sell it at the end of the trading day. You can’t go back on your decision to invest in a property at the click of a key on your keyboard.

It may be necessary to hold the property for several years to realize the anticipated big returns.

It’s interesting to note however, that most stocks dividend yields hover around 4% or less annually.  When you invest in a multifamily real estate deal, you start receiving income almost immediately. Investors are getting distribution checks every month from rental income and routinely the average annual returns even after fees, inflation and taxes, are above 10%.

2. Lack of diversification

If you’re putting all of your money into real estate you might be limiting your diversification.

In contrast, with stocks, by means of an index or mutual fund, you can have easy diversification.

However, diversification can be achieved in real estate investing; well-qualified advisors can help you to spread your investments across different communities and different types of property.

This is another advantage of syndication.

3. Transaction Costs

As we have seen, stock trading has much lower transaction costs than real estate.

Real estate is a longer-term investment and transferring property is expensive. There are title fees, attorney fees, agent commissions, transfer taxes, inspections, and appraisal costs.

Real estate is a tangible asset and as such for many investors, feels more real. A great appeal of this type of investment is its stability.

For many millions of people, this kind of investment has generated consistent wealth and long-term appreciation.

Real estate investment provides a very consistent and stable rental income. Having a home is a vital necessity for all people, and as a result, rental investors are relatively protected even during economic downturns.

Positives

1. Cash Flow

Property investment provides an opportunity to invest for cash flow which means buying a rental property for the income it generates each month.

With skillful management, this cash flow income can be increased significantly after your investment.

The passive income from your real estate investments can dramatically improve your quality of life.

Rental properties give a steady source of cash that keeps up with inflation.

With smart investment advice, real estate investing will bring a consistent stream of passive income.

Many investors are often able to earn cash flow completely tax-free.

2. Tax Advantages

The government gives many tax advantages to those that effectively help them with their responsibility to provide suitable housing for the populace. Owning real estate brings many tax advantages, not least of which is depreciation.

Depreciation is a key tax advantage with real estate investment.

Real estate investors earn back the cost of depreciation over a period of time after the initial purchase.

Because you are depreciating an asset that increases in value, you receive a tax credit accordingly.

This tax credit is received in addition to property maintenance and other costs that you can take away from the rental income you receive.

When you add in ‘bonus depreciation’ and ‘1031 Exchange,’ the tax advantages are truly extraordinary.

3. Hedge against Inflation

Depending on the type of securities you hold, Inflation can be problematic. Real estate investing serves as a hedge against inflation. The value of the property is tied to inflation as replacement cost goes up and the rent of the tenant is adjusted upward.

Summary

Investing in multifamily properties brings excellent returns with low volatility and many other financial advantages.

A great advantage of investing through syndicates rather than making a self-directed investment is that you get to leverage the investment company’s expertise. 

With a syndicator, you can bank on the knowledge and skills of several real estate professionals. 

Many investors don’t have the time or inclination to learn every aspect of owning and managing real estate investment, for example, negotiating purchase agreements, financing a purchase, negotiating leases and managing the property.

We look forward to supporting you in your desire to expand your wealth and reach your goal of financial freedom by means of multifamily real estate investment.