Investing passively in real estate syndications offers a unique opportunity to receive regular income distributions over the life of the investment. However, it’s essential to grasp the concept of cash distributions and accrued income to make informed investment decisions.
Cash Distributions vs. Accrued Income
Let’s begin with the basics. Cash distributions are payments made on a monthly or quarterly basis, representing a portion or the entirety of the preferred return on your investment. These distributions directly result from the actual cash flow generated by the property, such as rental income.
Accrued income, on the other hand, refers to any portion of the preferred return that isn’t immediately paid out during the distribution cycle. Instead, it accumulates over time, awaiting future opportunities for disbursement.
Understanding Distribution Scenarios: A Year-by-Year Example
Consider an investment of $100,000 with a projected 7% preferred return in the first year. If the property generates sufficient cash flow, a 3% preferred return could be paid out, resulting in $3,000 in cash distributions for the limited partners. The remaining 4% ($4,000) of the preferred return would then be accrued and paid out at a later time, typically when the property experiences increased cash flow or undergoes a capital event like a sale.
In subsequent years, distributions may fluctuate based on various factors. For instance, if there are unforeseen circumstances like a natural disaster or if the management team is building up reserves for future economic uncertainty, no distributions may be paid out. During this time, accrued income continues to accumulate. By the end of year two, if no distributions were made, the accrued income would amount to $7,000, adding to the previous year’s accrued amount. This pattern continues throughout the investment’s lifecycle until a capital event occurs, at which point the full accrued amount is paid out.
Asset Sale and Distribution Process
Upon the sale of the property, the accrued amount is typically paid out first, followed by the return of the original capital to investors. Finally, profits are distributed according to the predetermined split between limited partners (LPs) and the ownership group.
Cash Reserves and Asset Cash Flow
At Spark Investment Group, we prioritize maintaining cash reserves at both the fund level and individual asset level. By raising funds that cover the purchase price, necessary capital expenditures, and reserves, we ensure that cash distributions are paid from the direct cash flow of the property.
In value-add investments, cash flow potential tends to increase over time as expenses decrease. While distributions may be lower in the initial years, cash flow typically grows in years three, four, or five. This growth enables the potential for full preferred return payments and the disbursement of accrued income. However, it’s important to note that accrued preferred return may extend throughout the investment’s lifecycle, only being paid out during a capital event.
Preferred Return vs. Cash Distributions
The preferred return represents the return limited partners receive on their invested capital over the hold period. For example, if you invested $100,000 with a 7% preferred return, you would receive a 7% return annually throughout the property’s hold period. Differentiating between preferred return and cash distributions is crucial, as cash distributions depend on the property’s actual cash flow at any given time. If there is sufficient cash flow, the full preferred return amount can be paid out. Otherwise, distributions may be a percentage of the preferred return, with the remaining amount accruing over time.
Cash-on-Cash Returns and Differentiating from Preferred Returns
Cash-on-cash returns, also known as the cash yield, measure the performance of an investment property and provide investors with an understanding of the potential cash distributions over the investment’s lifespan. It is important to note that cash-on-cash return focuses on the cash in investors’ pockets throughout the investment, while preferred return represents the return over the investment’s lifecycle.
For example, if a deal projects a 6% cash-on-cash return over the hold period, it means investors can expect an average annual return of 6% on their invested capital.
Distribution Frequency: Monthly vs. Quarterly
While some investments offer monthly distributions, at Spark Investment Group, we primarily focus on quarterly distributions. Quarterly distributions help manage cash flow and strive to align with the preferred return. However, it’s important to remember that even with quarterly distributions, any unpaid return will accrue.
Investing in real estate syndications allows investors to receive cash distributions and potentially build accrued income over the life of the investment. Understanding the dynamics of cash distributions, accrued income, preferred return, and cash-on-cash returns empowers investors to make well-informed decisions. As with any investment, risks are inherent, and careful consideration of these factors is vital. By partnering with a trusted team and leveraging the benefits of real estate syndications, investors can navigate the world of passive investing and work towards achieving their financial goals.
To learn more about real estate investing and syndications, reach out to us at https://investwithspark.com/contact/ today!