The U.S. commercial real estate (CRE) market reached a valuation of $22.5 trillion in the fourth quarter of 2023, making it the fourth-largest asset market after equities, residential real estate, and Treasury securities. CRE investments are an increasingly attractive avenue for serious investors looking to diversify their portfolios and generate passive income.
One of the key ways investors benefit from these opportunities is through CRE distributions, which are payments made from a property's rental income or from one-time events, such as refinancing or the sale of the property.
This guide will go into the key features of CRE distributions, focusing on investment deals involving sponsors (General Partners) and passive investors (Limited Partners). We will address the following questions:
- How often are CRE distributions made?
- How are CRE distributions shared between the investors who actively manage the investments and those who merely contribute capital but do not take part in the management of the property?
- What are the tax implications for investors receiving CRE distributions?
Finally, we will discuss what you can do as a passive investor to safeguard your position. This section at the end of the post is especially important, as the last thing you want is to get an unpleasant surprise when you receive a distribution payment.
Are Distributions to Investors Guaranteed?
Let us start with a basic question: Are distributions written into the contract when investors contribute capital? In other words, are distributions guaranteed?
The General Partners of the investment firm make distributions from the property's cash flows. If the investment performs as expected, it is reasonable for investors to expect to receive distributions.
However, you must remember that the performance of CRE investments is subject to various factors that can influence the property's returns. A rise in vacancies could lead to a fall in rental income. Interest rates may shoot up, resulting in a higher-than-anticipated portion of the income from the property being required to be paid to lenders. Nothing may be left over to pay the investors who contributed equity to the project.
The short answer to the question, "Are distributions to investors guaranteed?" is no, they are not. CRE investments do not provide a fixed income. Investors receive payments only when there is surplus cash available for distribution.
Periodic and Lump-Sum Distributions
Investors receive two types of payments–periodic and lump sum. The first category is sourced from the rental income the property makes. The second is sourced from refinancing the property or from its sale. Let us dig a little deeper into each of these two categories:
• Periodic Distributions: These are received monthly, quarterly, or half-yearly. The investment firm could also make periodic distributions to investors annually.
• Lump-Sum Distributions: Lump-sum distributions are non-recurring and are triggered by two types of events:
- From the Sale of the Property: Investors may get a one-time payment if the property is sold for a large enough sum. Remember that lenders would need to be paid first.
- From the Refinancing of Debt Taken to Purchase the Property: If the value of the property increases, the sponsor may obtain refinancing for a sum that is greater than the original loan amount. In this situation, the surplus could be paid to investors.
The Distribution Waterfall — How It Works
A CRE distribution waterfall describes how different categories of investors will share the surplus cash generated by a property investment. The proportion in which the money will be shared and the order in which it is paid are laid down in the transaction's private placement memorandum and operating agreement.
A CRE investment deal involves sponsors (General Partners) and passive investors (Limited Partners). The former put up some equity capital, while the latter put up the rest. A CRE investment for a property that costs $10 million may be structured as follows:
- Sponsors contribute $1 million in equity.
- Limited Partners contribute $3 million in equity.
- A bank lends the remaining $6 million.
Components of a Typical Distribution Waterfall
The distribution waterfall will describe how the cash flows from the property are shared between the sponsors and the Limited Partners. A typical distribution waterfall could operate as follows:
• Return of Capital: Investors would receive the initial capital they had put up.
• Preferred Return: Investors would earn a specific return before sponsors receive a share of the profit.
• Catch-Up Provision: The surplus cash would be paid to sponsors, allowing them to "catch up" with investors in terms of the return the investors have already made.
• Promoted Interest: After the investment surpasses an agreed-upon threshold, the General Partners could receive a larger proportion of the remaining profits. This is the reward the sponsors earn for their successful management of the investment and the risk they have undertaken in agreeing to pay the Limited Partners before becoming eligible for payments themselves.
Tax Implications of CRE Distributions
Limited Partners would receive complete details of the capital they have put up as well as the distributions they have received in Schedule K-1 (Form 1065) supplied to them every year by the investment firm. The K-1 contains several key pieces of information:
• The percentage you own in the LLC. (Typically, CRE investments are made through a limited liability corporation.)
• Your share of income or loss.
• The rental income you have earned from the property.
• The depreciation deductions passed through to you.
• The capital gains or losses passed through to you.
The key point to remember is that the LLC is treated as a pass-through entity. This implies that your share of income and expenses is passed on to you and taxed according to the income tax rate that applies to you.
What Passive Investors Can Do to Protect Their Interests
Investing in a real estate syndication carries risks. For passive investors, it is essential to conduct thorough due diligence before committing their capital. Start by carefully reviewing the performance of the investment firm. How have their projects fared in the past? Do they have a good reputation?
You should also carefully examine the Private Placement Memorandum and Operating Agreement. Understand the risks involved and pay special attention to the distribution waterfall and the clauses that describe how the profits will be shared. If you have difficulty figuring out what the legal terms mean, it could be a good idea to seek a qualified attorney's help. A small investment in legal fees could help save you from an unpleasant surprise later.
The Bottom Line
CRE investments can offer attractive returns, but they can also be high-risk. Investors must understand how distributions work, the tax issues involved, and the transaction's legal framework. The best approach for investors is to conduct the due diligence carefully and take the right guidance before committing their funds. If you do this, you will increase your chances of making a successful investment.
