Investors often approach a deal with the same fundamental question – what’s the bottom line return? Yet the answer to that question is not always simple. There are different metrics that paint a picture as it relates to: 1) exactly how much will an investment pay out; and 2) when an investor is likely to see all or part of that return in their hands.
One such metric, the internal rate of return (“IRR”), gives the investor the “big picture” number on overall profitability. One of the notable aspects of IRR is that it takes into account the time value of money. That is an important consideration for real estate, which often involves holding periods of 5, 7 or 10 years or more. However, the IRR does not allow for much insight into the level of annual yields. One metric that helps to bridge this gap is is the cash-on-cash yield, often referred to simply as the cash yield.
While we published an article earlier this year on the definition of cash-on-cash returns, we now take the next step. In this article, we begin by revisiting the definition but then move on to highlight the differences between cash-on-cash yields and cash distribution yields.
The cash-on-cash yield is a periodic, typically annual, rate of return that calculates the cash income earned on the cash invested in a property for that period:
Annual Net Cash Flow / Invested Equity = Cash-on-cash Yield
For example, if an investor places $10,000 into an investment that produces $1,000 per year in net cash flow, then the cash-on-cash yield is 10% per year. While this is a relatively simple calculation that gives a good idea of the cash an investor can expect for any given year, there are at least two substantial caveats that investors should note.
First, the cash-on-cash yield is not a coupon. Specifically, the targeted cash-on-cash yield does not necessarily equal cash distributions. In the example above, the $1,000 of net investor cash flow need only be produced at the entity level in order to produce a 10% cash-on-cash yield. However, if the sponsor of that investment chose to only distribute $500 of the investor’s share of net cash flow and reserve the balance, then the cash distribution yield drops to 5%. The investor still owns the other 5%, it just hasn’t been paid out. Therefore, it’s important to understand that cash distributions can be delayed or withheld, accumulating to be paid out at a later date or, potentially, re-invested into the property.
Second, the cash-on-cash yield is not particularly useful to determine the tax and promote treatment of distributions. In order to understand all of the implications of regular distributions, the investor should consider how the sponsor’s plans for taxes and how the distribution affects the investor’s capital account, which we will discuss in further detail below.
Cash-on-cash yield v. Coupon
The potential disparity that can exist between cash-on-cash returns and cash distributions goes to show why it is important for investors to look at offering information that details payouts on cash distributions. Frankly, some sponsors are more willing than others to provide full transparency on distributions. Sponsors want to maintain flexibility in managing real estate and executing the business plan. In addition, the more uncertainty that exists in a business plan, the more uncertainty as to how much of the cash-on-cash return will actually make it into the investor’s pocket in terms of quarterly or monthly distribution checks.
Individuals seeking real estate investments that deliver reliable cash distributions often choose very stable investments such as a core, Class A office or apartment building or a triple net lease property that functions much like buying a bond. Those buying into a value-add or opportunistic investment where there is more risk to the business plan accept more uncertainty when it comes to collecting on cash distributions. Sponsors don’t sit on cash needlessly. If a sponsor ultimately elects not to distribute excess cash flow it likely means they are reinvesting it to add additional value to a property and, ultimately, achieve higher overall returns. Think of it as a commercial real estate version of a dividend reinvestment program.
Cash-on-cash yield v. Return on Capital
One limitation of the cash-on-cash yield is that it does little to help an investor determine how sponsors treat distributions for waterfall and tax purposes. Because it is solely a measure of a period’s distribution over the initial cash invested, it fails to define whether some or all of the distribution is treated as a return of capital. If the investor expects distributions to be treated entirely as return on capital but the sponsor treats part or all of the distribution as return of capital, the investor could be surprised upon the sale of the asset because the promote may kick in sooner than expected.
When it comes to treatment of distributions, there is no right or wrong method. Often, investors prefer distributions to be treated as return of capital because: 1) it makes those distributions tax free and concentrates profits into capital gains upon sale; and 2) it incentives the sponsor to return capital as fast as possible to the investor, thus taking risk off the table. Therefore, it is important to evaluate the sources and treatment of distributions in addition to the amount for the life of the investment.
Ultimately, cash-on-cash yield is another metric that investors can use to assess the potential risks and rewards of real estate investment opportunities. As part of its mission to provide greater transparency and access to real estate investors, CrowdStreet makes a point to include detail on cash-on-cash yield and cash distributions in offerings posted on the CrowdStreet Marketplace. In addition, CrowdStreet makes a point to for sponsors to provide targeted cash-on-cash returns in CrowdStreet Marketplace offerings and to describe the timing of targeted distributions. To learn more about online real estate investing, and to register for a free commercial investing account, please click JOIN NOW.