As noted in the preceding real estate snippet articles, distributions is how investors and operators get paid during the life of a deal before the gain from sale arrives. And while understanding the timing of distributions is important, so is understanding the structure of such distributions.
So long as the property generates sufficient cash flow, typically the distribution comprises of the preferred return as well as the pro rata profit share. The preferred return, as the name implies, shows preference of the LPs ahead of the GPs. It is paid first, before the pro rata share of profits is distributed.
Preferred returns are not guaranteed and depend on the cash flow generated by the property. As such, it is important to understand how they are treated in the event there is a shortfall.
The most typical structure is cumulative, i.e. the preferred balance due carries over into the next year. LPs may not receive the return as planned but will not lose on it (unless the overall investment suffers a loss). And if it keep accumulating till sale, such cumulative preferred return accrued to the LPs will be typically paid fist, followed by the LP’s share of the gains, and lastly the GP’s share of the gain.
Cumulative and compounding is another method, whereby the preferred return not only accumulates over time, but the rate is calculated on the accrued balance (vs. the original principal balance). This method is less common and certainly more beneficial for the LPs.
Preferred return may be calculated on returned or unreturned capital contribution principal amount. This is why it is important to understand whether distributions constitute return on capital (most common) or return of capital (less common). Basing distributions on unreturned capital is most common and more beneficial for LPs. If distributions count towards return of the principal investment balance, then the preferred rate is based on the decreasing balance, and as such those monthly (or quarterly) cash flows diminish over time.
It is just as important to understand the cash flow waterfall. In most deals, a simple waterfall structure like 70% LP and 30% GP, first distributes the preferred return, then the profits on a pro rata ownership share. However, in some deal structures, the profit share may change after a certain IRR/ AAR/ equity multiple hurdle is met. An example of such would be, 8% preferred return and 70% LP-30% GP profit share paid until sponsor hits an IRR of 15%, at which point profit split changes to 50% LP-50% GP. There could be multiple tiers/IRR hurdles built in, typically increasing the sponsor’s share of the profits.
The devil is in the details. As such, it is important to understand the distributions timing and structure upfront, so you have clear expectations on timing of cash flows and avoid surprises over the lifecycle of a deal.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.