Cash from month one at 7%, or nothing at all until sale at 9% accruing

Question

Two offerings on the same portal, both multifamily, both roughly four to five year holds, and the distribution structure is the only thing I can't reason my way through.

One pays quarterly from the first full quarter after closing, 7% annual on invested capital, described as a current preferred return. Property is 91% occupied at acquisition and throws off cash on day one. Sources and uses shows a line called "interest and distribution reserve" of about $1.1M on a $14M raise, which I think means part of my own money comes back to me as my first year of distributions.

The other pays nothing until a capital event. 9% preferred, accrues and compounds annually on unreturned capital, paid out at sale before any promote. Property is 68% occupied, heavy renovation, so there's genuinely nothing to distribute for two years and they say so plainly.

The argument for current pay is that money in hand is money you can't lose to a sponsor's later decisions, and a deal that can actually pay you every quarter is telling you something true about the asset. The argument for accrual is that 9% compounding for four and a half years is a much bigger number than 7% simple, and paying distributions out of a reserve funded by the raise is theater that costs you the fees charged on capital that was never really deployed.

I've read both sets of documents twice and I still can't decide whether the reserve line is a red flag or just normal mechanics for a deal that hasn't stabilized rents yet.

derekj19 · Accepted Answer

The reserve isn't a red flag by itself, wren. It's a red flag or it isn't depending on one thing you can check in the documents.

Go to the operating agreement and find how distributions are applied. Two common versions. In the first, cash paid to you from the reserve is treated as payment of the preferred return, so the pref clock resets and your unreturned capital stays at the full amount. In the second, it's treated as a return of capital, so your capital balance drops and future pref is calculated on the smaller number. The first version means you're being paid your own money and it still counts as yield, which is the version worth being annoyed about. The second at least reduces what's owed to you honestly.

Then check the fee definition. If asset management is charged on committed or invested equity, you pay a fee on the 1.1M reserve for the whole hold. If it's charged on deployed equity or on gross asset value, the reserve costs you less.

On the 68% deal, the thing to check is whether the 9% compounds annually or is simple, and whether it accrues on unreturned capital or on original contributed capital. Those two phrases sit in the same paragraph in most documents and they produce very different exit numbers.

Having done this on a few offerings, here is what I keep finding: a reserve on a 91% occupied stabilized asset means the debt service is tighter than the occupancy suggests. Ask them what the year one DSCR is without the reserve. That answer tells you more than the whole distribution debate does.

chriswalton8 · Answer

I'm still learning how this money moves, but the reserve thing bothers me on principle. If they raise 14 and hold 1.1 back to hand me my own money on a schedule, the asset management fee is being charged on all 14 the whole time. Am I reading that right or is the fee usually charged on deployed capital only?

megan_doyle15 · Answer

91% occupied and it still needs a distribution reserve? That's the part I'd ask about.

Rena Guide · Answer

A few definitions first, since the two structures use the same words differently.

A preferred return is a rate investors are entitled to receive before the sponsor shares in profits. Current pay means it is distributed as cash while you hold the investment, usually monthly or quarterly. Accrued means it builds up unpaid and is settled later, typically at a refinance or sale. Compounding means unpaid preferred return itself starts earning the preferred rate, so 9% compounding is meaningfully more than 9% simple over four or five years.

A distribution or interest reserve is cash set aside out of the raise at closing specifically to fund early payments before the property produces enough of its own cash flow. It is normal in deals with a lease-up or renovation period, and it is disclosed in the sources and uses table, which is where you found it. When distributions come from that reserve, the cash you receive is partly your own invested capital coming back, and the offering documents will usually say whether those payments reduce your capital account or count against the preferred return.

So the question worth asking each sponsor in writing is whether early distributions are treated as return of capital or as payment of preferred return, and what the asset management fee is calculated on, invested equity or deployed equity. Those two answers change the comparison more than the headline rates do. How each structure is taxed to you depends on your situation and belongs with your accountant.

luis_carrera · Answer

Ran both at four and a half years on 50k just to see. 7% simple current pay is about 15,750 of distributions. 9% compounding annually accrues to roughly 73,600, so about 23,600 of preferred sitting on top of capital at exit. That gap is big enough that the current pay deal has to be materially safer to justify itself, and I don't think 91% occupancy plus a reserve gets you there. Though I'd want to know what the accruing deal pays if the exit slips two years past plan and the pref eats the whole equity above the debt.

renee_dubois · Answer

Having actually collected rent, I'll say the quarterly check does something the spreadsheet doesn't capture. Four years of silence is a long time to hold a position you can't sell, and people make bad decisions at month 30 of silence. Still, @windlass has the math right and I voted for the accrual anyway.

Cash from month one at 7%, or nothing at all until sale at 9% accruing

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