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 sponsor capital stack is returned going to be?
Questions #2: When a syndicator purchases questions to ask when buying an apartment complex, how can they determine what the profit splits 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.
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The preferred return is a threshold return that limited partners are offered prior to the general partners receiving payment. If the preferred returns is 8% paid out monthly, for example, the limited partner will receive the first portion of co investment and the monthly cash flow up to 8%.
To calculate the preferred return threshold amount use the preferred return formula, and preferred rate of return private equity position investors and multiply the total equity investment from limited partners by the preferred set percentage return of capital contributions. If the preferred return hurdle is 8% and limited partners invested $1 million, the annual return rate hurdle is $80,000 (0.08 * $1,000,000).
Typically, profits above the preferred return calculations private equity fund are split between the general partners and limited pari passu partner.
The general partner sets the preferred return percentage based on the business plan, the goals of their limited partner interest basis, and what other general partners who are implementing similar business plans are offering compounding basis capital contribution.
When underwriting a deal, the average annualized cash flow should exceed the preferred return of capital amount offered to equity investors so that you can distribute the preferred equity.
To calculate IRR, you need to know the amount and date of all payments to an equity investor capital is returned. Unlike cash-on-cash return and equity multiples, IRR takes into capital account the time market value of money (i.e., $100 received today is worth more than $100 received cumulative preferred return of preferred equity multiple of investor 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 preferred return equity investments IRR calculation.
When underwriting a deal, you set income and expense assumptions based on how the property is currently operating agreement, 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 on January 1.
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Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any real estate investment securities or to make or consider any capital investment advice or course of action in equity investment in pari passu pref.