I recently received a question from a passive investor in one of my apartment syndication deals. They wanted to know the difference between the preferred return and the cash-on-cash return projections.
The investor is correct in thinking that the preferred return and the cash-on-cash return are two difference things. Also, the preferred return and cash-on-cash return function differently for Class A and Class B investors.
In this "Ask The Expert" post, I will include my reply to this investor's question. The preferred return is the threshold return that Limited Partners (LPs) receive before General Partners receive any profits. The cash-on-cash return is the overall projected returns to the LPs over the lifetime of the project.
For our deals, we distribute monthly returns. So, we prorate the preferred return monthly. The Class A investors receive their prorated monthly return first and the Class B receive their prorated monthly return second. Let's take a Class A investor who invested $100,000 and a Class B investor who invested $100,000 as an example. The Class A investor is offered a preferred return of 10%, so they will receive $10,000 per year, or $833.33 per month.
The Class B investor is offered a preferred return of 7%, so they will receive $7,000 per year, or $583.33 per month. There are two scenarios where the Class A and Class B investor wouldn't receive their $833.33 and $583.33 per month. The first scenario would be if the year 1 return projection is less than the preferred return offered. The second scenario would be if the return projections were equal to or greater than the preferred returns but the actual returns were less than the preferred return. In both cases, the process will depend on what is stated in the PPM. For our deals, the difference between the preferred return and the actual return would accrue and be paid out in the future. Some syndicators will offer this same structure whereas the preferred return will not accrue for others.
After owning a property for 12-months, we will evaluate the year 1 performance of the deal. Any cash flow above the preferred return will be distributed at the end of year 1 based on the profit split structure outlined in the PPM. For our deals, the Class A investors are offered a higher preferred return and do not receive a profit split. The Class B investors are offered a lower preferred return and do receive a profit split. Therefore, profits above the 7% preferred return are split between the Class B investors and the General Partners.
Regarding the cash-on-cash return, we present two cash-on-cash return metrics to our investors - the return excluding profits at sale and the return including profits at sale.
The Class A investors do not participate in the upside and receive a 10% preferred return each year until the asset is sold. Therefore, their preferred return and overall cash-on-cash return excluding and including profits at sale are the same, because they don't receive a portion of the ongoing profits or the profts at sale. The average annual return paid to the Class A investors is 10% excluding profits at sale and 10% including profits at sale.
The preferred return to the Class B investors is not the same as either cash-on-cash return metrics because they do participate in the upside of the deal. The annual average cash-on-cash return excluding the profits at sale includes the annual preferred return plus the average profit split.
For example, let's say a Class B investor invests $100,000 into an apartment syndication with a 7% preferred return and a projected 5 year hold. The annual cash-on-cash return projections for year 1 to 5 are 7%, 7.4%, 8.2%, 9.1% and 9.4%. The average of these 5 returns is 8.2%. So the average cash on cash return real estate to Class B investors is 8.2% excluding profits from sale.
Additionally, the projected profit at sale is approximately 59% of the Class B investor's initial investment. This equates to a year 5 return of 68.4%. The average of year 1 to 5 return including the profit from sale is 20%.
The preferred return for year 1 to 5 is still 7%, which is paid out monthly. Assuming the deal perfectly meets expectations each year, the Class B investor would receive no extra distributions year 1, 0.4% year 2, 1.2% year 3, 2.1% year 4, and 2.4% year 5. For our deals, this extra distribution is every 12 months.
However, we re-assess the performance of our deals every 12 months. If the deal exceeded our expectations, we determine how much extra to distribute to our investors. If, for example, we determine that we can distribute 7.2% to our Class B investors at the end of year 1, the extra distribution would be 0.2%. We repeat this process every 12 months and send out extra distributions, if applicable, at the end of each 12 month period. If we projected a return that is greater than the preferred return and hit those projections, the Class B investors will receive an extra distribution. If we exceeded that return projection, the Class B investors will receive an even higher extra distribution.
Overall, the difference between the preferred return and the cash-on-cash return are the profits. The preferred return remains the same throughout the hold period. The cash-on-cash year deviates from the preferred return when the cash flow is greater than the preferred return. In our example, the preferred return is 10% every year for Class A investors, paid out monthly, and the cash-on-cash return is 10% every year. The preferred return to Class B investors is 7% every year, paid out monthly, and the cash-on-cash returns are 7%, 7.4%, 8.2%, 9.1% and 9.4% for year 1 to 5 excluding the profits at sale and 7%, 7.4%, 8.2%, 9.1% and 68.4% including the profits at sale.