One of the many reasons I like to invest in real estate is the benefit of cash flow, which usually comes in the form of monthly or quarterly distributions.
However, is receiving a distribution a good or a bad thing?
Our natural inclination is to think that it is a good thing. However, as usual, it is important to peel the onion a layer deep and look at the numbers.
The key question to answer here is: What is the source for that distribution – existing cash reserves OR cash flow from operations?
Before we opine, let’s ensure we are all on the same page re what cash flow from operations is. That is the net operating income (measured as effective gross income less operating expenses) less debt service less asset management fees. The balance is cash flow available for distributions.
One may argue that capex should also be subtracted from that number. However, expenses for various capex projects in most cases are reserved for upfront and funded from the capex reserve account. If for any reason that is not the case, which raises other concerns, one should also subtract capex to arrive at the free cash flow number.
Then compare the projected cash on cash return for the period to determine the amount of projected distributions. For example, a 10% cash on cash return in Year 3 on a $1,000,000 investor equity investment (for the entire deal) will result in distributions of $100,000.
Lastly, if the cash flow available for distributions is a positive number and exceeding the expected annual distribution, as illustrated in the number above, one can rest assured that the subject distributions are not coming from the rainy day fund (partially or fully).
However, if they are partially or fully sourced from reserves on a consistent basis, this should not be a cause for celebration but rather a cause of concern. More specifically, it begs the question on what is causing the cash flow compression/negative cash flow and what plan the management team has to turn around the situation. If the problem remains unaddressed, reserves will be eventually depleted, leading management to make tough decision, which include a high probability of a capital call.
On that note, another related question we are often asked is whether pausing distributions is a cause for concern. It will likely at a minimum raise a few questions the operators will need to address.
In some cases the operator may pause distributions out of abundance of caution. An example of that is the period of 2022-2023, when there were certain operators performing well but faced with the unexpectedly rapid increase in interest rates and therefore forced to reserve/escrow extra for the purchase of future rate caps, as required by their lender OR simply pausing to accrue reserves for a potential refi (which in that environment given lower LTVs would require a loan pay down). In some cases, the operator may also pause their asset management fee (and if vertically integrated may also lower the property management fee). This is not a happy moment but the more prudent strategy to preserve liquidity and weather the storm vs. doing a capital call a couple of months later. While distributions are paused, they are still accruing and therefore payable once the project turns around.
In other cases, however, the asset is not only impacted by the rate environment but also by poor operations. In that case, pausing distributions slows the bleeding but does not resolve the underlying issue and even then may eventually lead to a capital call or loss of the property. Aggressive underwriting and/or lack of operational expertise unfortunately led to foreclosures and capital calls for many assets in the space during that period.
Thus, while a pause of distributions may not necessarily be a happy moment, it might be the most prudent decision to make from a longer term perspective and protection of the investor principal investment.
And as to receiving your monthly distributions….well, make sure you check the operating statements and balance sheet to determine if you should be celebrating or picking up the phone and raising important questions to the sponsor.
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.