The beauty of investing in an existing real estate business, like value-add class C/B multifamily, is that generally the properties have some cash-flow from day-1 as they have existing tenants that pay rent. This approach is less risky and should enable investor returns quicker as compared to investing in a development, flip or a start-up, where the risks are higher and it could take years for profitability.
Passive investors are pleased when they get distributions that meet or exceed projections. However, I believe that most investors don’t look at the nature/source of the distributions and just assume they are generated from operating cash flow. But, if the distributions aren’t from true cash-flow, this can lead to significant problems later in a deal’s life-cycle.
The last 5-7 years prior to Covid-19 was a very forgiving environment especially in the multifamily space. Sponsors were able to generate cash flows due to exponential rent growth even if they had poorly capitalized deals, mismanaged their expenses/capex, etc. Furthermore, as interest-only periods expired, and operating cash reserves thinned, deals were able to be sold at huge gains due to compressing cap rates, which made sponsors look great and investors very happy. Everyone in the industry, including myself, has benefited from these trends. However, this pandemic driven crisis will certainly change the landscape and I believe superior asset and P&L management will separate strong sponsors from the rest going forward.
If you are a seasoned passive investor, I am sure you have encountered situations like the following:
- Distributions starting off strong, at or above projections, and then they start dwindling over time
- Sponsor’s update just states they are making a distribution but you have no idea what the time period and annualized return is
- The sponsor seems to magically always hit the proforma return spot on
- Distributions decrease once interest-only period or major capex ends
In this article, I will describe some reasons why the above circumstances can occur and what investors should watch out for to ensure they are truly getting return on investment via cash-flow versus a return of capital/reserves/capex.
1) Sponsors Not Assessing True Cash Flow Generated from Operations
If you have read my previous articles, including Why Operating Cash Flow is more important than NOI, you will notice I am a big proponent of sponsors truly assessing the operating cash flows generated by a property. There are a lot of nuances in calculating this figure and it goes well beyond NOI or Net Income. Further, the time period in question is also very important, as upon acquisition a property’s P&L will show a low expense load. If this is not accounted for and normalized, distributions higher than supported can be made. Further, tax and insurance expenses are typically estimated and accrued and need to be re-estimated upon reassessment or renewal, before the cash flows are normalized and assessed for distribution. Taking the financials at face value, especially in the initial months, is a recipe for disaster and this ties into points #2 and #3 below.
2) Setting and Forgetting Monthly Distributions
There are many sponsors that market getting monthly distributions immediately in the first month, which sounds fantastic as an investor. But the challenge with this approach is that the sponsor is most likely guessing as to what the distribution is going to be based on the seller’s T3 or their proforma, as there is no actual data supporting the distribution. In my experience, there are always nuances upon property takeovers (e.g. poor tenant quality, higher delinquency, surprise deferred maintenance, etc.) and it takes a few months for the new ownership to get their hands around the property and to start seeing a more predictable income stream, which is the point I believe monthly distributions may make sense. In my experience and opinion, this takes 3-6 months post acquisition, depending on the type of deal (e.g. value-add, yield, etc.).
3) Distributions from Equity Raise or Reserves
There are some deals that don’t generate enough positive cash flow but still make distributions. This is because, knowingly or unknowingly, the sponsors are making distributions from additional equity raised (or from excess reserves) as they want to hit their projected (and preferred) returns. What is troublesome here is that sponsors will get their compensation (i.e. promote) on investors equity capital rather than on operating results, which is absurd especially if not disclosed to investors. There is nothing wrong with raising more money initially as it’s a prudent approach to have the reserves. However, when it is determined that the deal no longer needs the excess cash, the sponsors can return the investors capital, but it should be treated for what it is; a return of capital NOT a return on investment that sponsors get compensated on.
4) Mismanaging of Capex
Most value-add properties have sizable capex budgets. As with any budget, they become stale immediately as unplanned things come up that result in budget variances. The challenge is managing the capex in a way where the sponsor understands what may be going over budget and reallocating the remaining capex. This is a separate discussion in itself but it does potentially impact distributions. Sponsors should be making distribution decisions based on operating cash-flow, which is different from capex activities. However, if unplanned capex is not monitored or reallocated within the original capex plan, then essentially these unplanned capex are being paid for by operating cash-flow and effectively reducing the cash-flow available for distribution. Hence, it is very important for sponsors to constantly view capex performance in conjunction with operating results.
Summary:
Sponsors could not have planned for a black swan event like Covid-19, but they could have prudently managed cash-flow and their distributions. If unwarranted distributions are made, then situations like Covid-19, could lead to financial struggles at the property that can’t always be bailed out via selling in a strong economy. This could lead to the need for additional cash via investor capital calls, which is the last call any sponsor wants to make. Thus, as a passive investor, it’s important to know the source of the distributions.
At Catalyst, before making any distributions, we always analyze cash-flows in detail, remove anomalies and normalize expenses, review our capex actuals vs. budget, understand our working capital needs, etc. to ensure the property will be in good financial condition post distribution. We always air on the side of being conservative and holding reserves and then as the income stream becomes more and more predictable, we can make special ‘catch-up’ distributions, as needed.
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