How Limited Partners Get Their Capital Back
A sponsor's most important job in a real estate syndication is protecting their investor's capital. Once the project begins the capital is invested for the next three to seven years, but eventually, the capital is returned. If you're a limited partner, it's essential to understand how and when you can expect to receive your capital back.
The length of time capital is held will affect returns. The amount of capital held also affects returns. A reduction in capital held will come with a reduced return. Each syndication is structured differently, but there are only a few dominant ways of returning capital.
Selling the Property
The easiest way to return capital is to sell the property. Once a property is sold, the first of the proceeds go towards returning investors' money. Ideally, the property is sold for a profit so that investors receive their money plus profit.
There are scenarios where a property is not sold at a profit and not all investor funds are returned because of a loss. Although uncommon, it is a risk. It is critical to evaluate the market, the deal, and the team before moving forward with an investment.
A different scenario than selling is executing a cash-out refinance on the property. An average business plan involves improving the property, therefore increasing the value of the property, and creating equity. This equity created can be taken out in a cash-out refinance to return some of or all of the investors' initial capital.
It's important for limited partners to check all the legal paperwork and understand the implications of capital being returned in a cash-out refinance event. In one scenario, the limited partners may stay invested in the deal even when they get their capital back, however, their preferred return will drop. In another scenario, the limited partners are cashed out of the deal once capital is returned.
Here's an example:
If someone invested $100,000 with an 8% preferred return, they would expect to receive $8,000 each year. After a refinance, they might get back $75,000 and only have $25,000 left in the deal. The preferred return is 8% on the $25,000 ($2,000). The refinance normally does not affect the profit splits, so they'll still get a split of the profits above the preferred return.
The amount of time that capital is actually invested depends on market conditions and the business plan. In some scenarios, the market conditions are very favorable and the property is sold earlier than anticipated with the same profit predicted or better. In other scenarios, the market may be unfavorable and the property may need to be held for longer than expected until the projected profit is reached or until the market is favorable to sell/ or refinance.
Return "Of" Capital Vs. Return "On" Capital
There is one other surprising way investors can get their invested capital back: through distributions. This is a return of capital through distributions, not a return on capital. It is a very important distinction.
Return of capital means that the investor distributions given reduce the amount of capital they have invested in the deal. The invested capital would slowly decrease and thus slowly decrease an investor's return. For example: If $100,000 is invested at an 8% preferred return, the monthly distribution would be $666. The following month the invested capital would now be $99,334 and the distribution would be $662.
Return on capital does not decrease an investor's equity. If there is a preferred return, the distributions remain the same as long as cash flow supports them. Over the life of the investment, receiving a return of capital yields a lower return than the return on capital.
Keep in mind that there is always risk in real estate investments, and it is possible that the limited partners will not get some of their capital back if the deal sponsor is untrustworthy or a deal performs poorly. Although, it is extremely unlikely that the value of a real estate investment will drop to zero since it’s backed by the physical asset. Even in a worst-case scenario such as the property burning down, the sponsors will have insurance to protect the invested capital.
To recap, investors can expect to receive their capital back at the end of the business plan through either a sale or refinance. It is essential for an investor to understand if they are receiving a return of capital or a return on capital, which determines their return structure throughout the deal. There are market risks that can tie up invested capital for longer, however, there is the same possibility of benefiting from the market, and getting a return of capital sooner than expected as well. All in all, it's important to speak with the sponsor and review what the structure is for a specific deal.