If you invest in real estate, it is important to understand the concepts of “return ON capital” and “return OF capital”. As a passive investor, fully understanding these concepts and their significance will help you become a more astute investor and optimize your investing strategy. Let’s dive in and break down Return ON Capital and Return OF Capital, discuss why they are both important, and go over the key differences and how they impact your return as an investor.
Return on Capital
Return on Capital is the return ratio or percentage that measures how well a syndicator turns investors’ equity into profits. When you get paid distributions from the property’s operations and net income produced, then you get return on your capital. For example, if you invested $100,000 and received a 6% return annually ($6,000), then your Return on Capital would be 6%. In other words, the Return on Capital is the amount of money that you receive each year as a result of making your initial investment.
Return of Capital
Unlike Return on Capital, Return of Capital happens when an investor receives their original investment back – whether partly or in full. Return of Capital is not considered income or capital gains from the investment, but it reduces your initial investment balance. So, with the $100,000 investment example, if you invested $100,000 and got $6,000 in Y1, then at the beginning of Y2, your investment balance is reduced to $94,000 ($100,000-$6,000). Essentially, Return of Capital refers to the payments that an investor receives which returns a portion of the capital that he or she invested back to him or her. In real estate, it usually takes a number of years until the investor has all of the capital that he or she invested returned to him or her. The Return of Capital is usually completed via a refinancing or sale, and not from the property’s income.
Why Does It Matter To Know The Difference?
Knowing the difference between Return on Capital and Return of Capital is important because Return on Capital lets you know what annual returns you can expect for your initial investment and Return of Capital lets you know the rate at which your initial investment can be recouped. Good real estate investors need to fully understand both of these figures before investing in a particular property. Once they do understand these figures, it helps them to decide whether or not a particular property will make for a good real estate investment.
Distributions to Investors
When investors are being paid their distributions, it is important to know whether they are being paid Return on Capital or Return of Capital. If your syndicator pays you distributions based on Return of Capital, then you will get lower returns each year, as your investment balance will shrink over time. Say you invested $100,000 in two syndications with identical 6% cash-on-cash return every year from the property’s income. If your syndicator is using the Return on Capital, then you will get paid $6,000 every year (6% of $100,000). However, if the syndicator is using the Return of Capital method, then in Y1 you will get 6%, but in Y2, the 6% will be calculated based on $94,000 (since the first $6,000 paid to you reduced your original investment from $100,000 to $94,000). Hence, in Y2 you will get paid only $5,640 (6% of $94,000), and in Y3 only $5,302 (6% of $88,360).
Using the Return of Capital to calculate returns from the property’s income will also artificially generate a higher IRR when the property is being sold, since by the time it’s being sold, your pro-rata share of the sales proceeds is calculated based on a much lower investment than your original $100,000.
Key Tax Differences Between Return on Capital and Return of Capital
Return on Capital and Return of Capital are taxed are very differently. Return of Capital does not include gains or losses. It is similar to getting your money back, so it is not considered taxable. This means that you can receive your full investment back from a Return of Capital perspective and not pay taxes on it up to the full dollar amount you put in.
In real estate investing Return on Capital, on the other hand, is considered rental income and is taxed the same way that other normal rental income is taxed for real estate investors. Note: The property’s depreciation schedule typically shelters much if not all of this taxable income during the hold period.
So, Which is the Better Option for Real Estate Investors?
If you are a passive real estate investor who invests in a syndication, then you can’t choose between Return on Capital and Return of Capital, as the syndicator will make that decision. There are pros and cons to each strategy. For example, with Return of Capital, there are significant tax advantages, but your payouts will mostly go down every year.
For Return on Capital, your distribution payments won’t go down over time in most cases, but they may be more heavily taxed. Which method is best for you depends on whether you just want to recoup your investment quickly with the lowest amount of tax possible, or whether you want to create steady cash flow that can last indefinitely for many years.
If it is the latter that you want, then Return on Capital is best for you. If it is the former, then Return of Capital is the better option.
Discussing The Distribution Arrangement With Your Sponsor
Before you enter into any real estate deal, it is crucial that you discuss the distribution arrangement with your syndicator or sponsor. The reason is because you want to make sure that you are comfortable with the distribution arrangement and make sure that it works well for you. Unfortunately, some real estate investors do not take the time to fully understand the distribution for the real estate deal and find themselves disappointed down the line when they realize that it wasn’t exactly what they wanted.
Some investors have higher thresholds for annual return percentages, and others have lower thresholds. You should figure out what your minimum annual desired Return on Capital percentage is before you enter into a deal that has a Return on Capital distribution setup. If you are going to go with a Return of Capital arrangement, you need to be fully aware of the time it will take for the full return of your capital.
Knowing the difference between Return ON Capital and Return OF Capital is important for real estate investors. Return on Capital will usually generate higher payouts (assuming that the investment is doing well of course) yet potentially commands higher tax payments, while Return of Capital strategy will result in lower payouts but will provide a tax advantage, since you should not pay tax when your initial investment is paid back to you. Once you’ve identified which strategies best serves your goals, vet your sponsor thoroughly, and only consider investments that align with your overall wealth building goals.
To learn more about real estate investing and syndications, reach out to us at https://investwithspark.com/contact/ today!