Why do you invest in private placements? Most of you will say because they offer something stocks don’t – periodic income plus appreciation.
Investors in private placements can expect distributions from cash flow (i.e., net income – debt servicing) from two sources:

  • Operations.
  • Sale.

Distributions of cash flow from operations are typically made on a quarterly, semi-annual, or annual basis, and of course, distributions of cash flow from a sale are made when the asset is sold.

Many private placements, including real estate syndications, take distributions further by giving investors first dibs on first dollar cash flows called preferred returns.

Preferred returns are distributions from cash flow calculated by taking a predetermined fixed percentage and multiplying by the amount of the investor’s investment (i.e., investment capital). Investor preferred returns are given priority and are made before any other distributions of cash flow.

In summary, here are typical distributions investors can expect from a private placement:

  • A preferred return of x%.
  • After preferred return, x% of remaining cash flow.
  • Upon sale, cash flow is first used to catch up on any unpaid preferred return, then distributed to investors to zero out their capital accounts. Investors receive x% of any remaining cash flow.

AN EXAMPLE…

Assumptions:

  • Year:  10
  • Net Cash Flow from Operations (Year 10):  $100,000
  • Preferred Return Rate:  8%
  • Investors % of Cash Flow from Operations:  20%
  • Investors % of Cash Flow from Sale:  20%
  • Accrued but Unpaid Preferred Return at the end of Year 10:  $0
  • Net Cash Flow from Sale at the end of (Year 10):  $5,000,000
  • Total Investor Capital:  $1,000,000
  • Number of Investors:  10

Distributions from Operations (Per Investor):

  • Preferred Return: $1,000,000 * .08 / 10 investors =  $8,000
  • 20% of Cash Flow After Preferred Return: ($100,000-$80,000)*.20/10 =  $1,840
  • Total Year 10 Return:  $9,840
  • Year 10 Rate of Return:  9.84%

Distributions from Sale (Per Investor):

  • Cash Flow from Sale:  $3,000,000
  • Unpaid Preferred Returns:  $0
  • Return of Capital:  $1,000,000
  • Distribution from Remaining Cash Flow: ($5,000,000-$1,000,000)*.20/10 =  $40,000
  • Average Annual Return from Appreciation: $40,000/10/$100,000 =  4%

Let’s say year 10 was a typical year for the fund in terms of returns. If you take the average annual return from operations of 9.84% and add the average annual returns from an appreciation of 4.0%, the investment delivered an average annual return of 13.84%.

ANALYZING THE DEAL…

Most investors would be happy with just an annual preferred return of 8%, but what is the likelihood of reaching the annual 9.84% return from operations?

To answer that question, we need to work backward to see how we arrived at the cash flow number and how likely it is for the fund to achieve the 9.84% target or any other annual return target.

Here are the foundational accounting concepts that we need to understand:

Scheduled Gross Income – The scheduled gross income is the total gross income that can be earned from rents in a perfect world. This assumes nobody misses a rent payment and that there are vacancies or losses.

Effective Gross Income – Of course, we don’t live in a perfect world, so we have to take into account contingencies — effective gross income factors in rent delinquencies, vacancies, and potential losses.

When analyzing a deal, you need to examine whether the sponsors are being realistic about the contingencies:

  • Are they over-optimistic about delinquencies or vacancies?
  • If they were projecting only a 5% delinquent rate when the 10-year average was 10%, how did they arrive at the 5% number?

Operating Expenses – These are the day-to-day expenses of operating the property. They can include employee wages, property management fees, landscaping, repairs/maintenance, professional fees, and marketing.

As above, if the sponsors are projecting to reduce expenses, do they have a realistic plan for doing so. What efficiencies, skills, or expertise do they bring to the table for reducing expenses?

Annual Operating Expenses – These are annual expenses incurred by the company, including taxes and insurance.

Net Operating Income:  NOI = Effective Gross Income – Total Expenses (Operating + Annual)

Mortgage Expenses – The servicing costs of any secured debt are obtained to finance the property.

Cash Flow:  Cash Flow = NOI – Mortgage

To determine whether the returns projected by the sponsors of a private placement are realistic, a potential investor needs to dig deep into the financial projections and the sponsor’s business plan for achieving their goals. Central to every business plan is to increase cash flow by improving effective cash flow and reducing expenses.

What is the sponsor’s plan for doing this?

If they have a specific plan for achieving their financial goals, you can have peace of mind knowing that your capital is in good hands. On the other hand, if the sponsor is overly aggressive with their projections with no plan in place, be concerned.