My first year of distributions on a hotel deal turned out to be my own money handed back

$25k into a small hotel LP two years ago. 96 keys, limited service, sponsor with three prior properties. I did what I thought was careful diligence, which for me meant reading the PPM twice, calling two prior investors, and checking the sponsor's other deals for anything public.

The deck said 8% preferred return, paid monthly starting at closing. That mattered to me. I liked that it started right away instead of waiting for the property to stabilize.

I got $1,650 over about eleven months and then the payments stopped. When I asked, the sponsor said the interest reserve was exhausted and distributions would resume when operations supported them. That was the first time I heard the words interest reserve.

I went back into the sources and uses page in the PPM, which I had looked at and not really read. The raise included a line for an operating and interest reserve of roughly $900k out of a $6.1M raise. That reserve was what paid me for eleven months. The hotel wasn't generating enough to cover debt service and a distribution, so the money that came to me every month was money I and the other investors had put in.

Then the K-1 arrived and my distributions were shown as reducing my capital account. So my $25k is now $23,350 on the books, and I have received no income at all in two years. Nothing has been stolen. The paperwork said what it said. I just read the return line and not the funding line.

What I'd do differently: for any deal that promises distributions before the property is operating well, find the exact line in sources and uses that funds them, and work out how many months of payments that pot covers. If the answer is eleven months, the deal is telling me it doesn't expect to be self-funding for eleven months, and I should plan on nothing after that.

Answer

1dmitri_v6CapitalPRO6

Three places to look, and they are usually three different documents.

Sources and uses, in the PPM or the offering summary. You want a named line for interest reserve, operating reserve, or working capital. Divide it by the monthly debt service plus the monthly preferred on the full raise. That quotient is how many months the deal can pay without operations, and it is the number the deck will never print.

The distribution section of the LLC agreement. Look for language permitting distributions to be funded from capital contributions or from reserves. If that permission is there, the word distribution in the deck carries no information about whether the property earned anything. Also look for cumulative and compounded next to the preferred return, plus whether unpaid preferred is paid before the sponsor's promote on a sale. vellum is right that this changes your position a lot.

The loan documents or the loan summary. Lenders on transitional hotel assets often require an interest reserve as a condition, and sometimes cash sweeps that stop distributions entirely once a coverage test is missed. If your money can be trapped by a lender test, the operating agreement's waterfall is not the only thing controlling your mailbox.

On the K-1 treatment: distributions that exceed your share of income generally reduce basis, and how that lands on your specific return is a question for your CPA rather than this thread.

canton, the useful thing here is that you can still get the accrual answer. Ask the sponsor in writing whether the unpaid preferred is accruing, at what rate, and where it sits in the waterfall on a sale. If it accrues and compounds ahead of their promote, your two dead years are recorded somewhere. If not, you know what the exit looks like now instead of at closing.

5 replies

3jordan_ellis2ActivePRO6

I passed on something with almost this exact shape six months ago, and only because a friend told me to search the PPM for the word reserve. The deck said 7% paid quarterly from closing and the sources and uses had $1.1M sitting there against a raise of about $7M. When I asked the sponsor how many months of preferred that covered, the answer took nine days and was a paragraph long without a number in it. That was my answer.

Still haven't done a deal. Occasionally that feels less stupid than usual.

1ehernandez74PO2BPRO5

canton, was the reserve labeled clearly in the sources and uses, or was it inside a bigger line like closing costs and reserves? I ask because I've seen both, and the second version is harder to catch on a first read.

The other thing I'd want to know before I did one of these: did the docs say what happens to the preferred once the reserve runs out. Does it stop, or does it keep piling up in your favor while unpaid? Those are very different positions to be sitting in two years later.

1raj_mehta14CapitalPRO6

That's the question I had too, anchor. Most of what I've been reading is notes and paper, and on a note the missed payment either accrues or it's a default. Equity seems softer than that. If the 8% preferred just accrues and compounds while unpaid, canton is owed a growing amount that gets paid before the sponsor's profit share on a sale, which is worth something even if the mailbox is empty. If it doesn't accrue, those eleven months are gone and so is everything since. canton, does your agreement use the word cumulative anywhere near the preferred return?

3chriswalton8CC1CPRO8

The reason this structure exists is that a raise that starts paying on day one is much easier to fill. An investor comparing two decks sees money moving in month one on one of them and nothing for eighteen months on the other, and month one wins even though the hotel is identical. So the sponsor sizes a reserve out of the raise, and investors fund their own early distributions.

It isn't automatically bad. A hotel in a PIP with rooms out of service genuinely cannot cover debt service, and a lender will often require an interest reserve anyway. What's misleading is calling that flow a return.

My first year of distributions on a hotel deal turned out to be my own money handed back

5 replies