When investing in a syndication, there are several different types of financial benefits, and no two syndications will look exactly alike in the amount of each benefit they generate. It’s important you ensure the investment you’re planning to make is positioned to generate the type and amount of returns that you are looking for.
For example, perhaps you’re retired and investing with the goal of receiving regular payments from your investment to cover your monthly expenses. In this case, certain syndications are going to be more attractive to you than others.
Likewise, if you have a higher risk tolerance and are looking for the largest total return on investment—and are willing to wait several years for it—other syndications will be a better option. Or maybe you don’t care as much about regular payments or massive returns, and instead are looking to generate tax benefits to offset other income from your portfolio. In this case, yet another type of syndication may be the best fit for you.
Long story short, each syndication will have a different profile for the returns it generates, and investors need to understand both what they need from an investment and what an investment is expected to provide.
Three Main Sources of Returns
When investing in a syndication, there are three main sources of returns a limited partner (LP) should expect to receive.
Cash flow
Cash flow is the recurring revenue investors should expect to receive based on the ongoing performance of the property.
Each year, the property will generate income through rents and other means. Some of that income will be used to pay operating expenses, like property taxes, insurance, maintenance, property management costs, etc. Additionally, that income will also be used to pay the lender their monthly mortgage payment.
Anything remaining is referred to as cash flow, which is money that can either be placed in reserves for future expected expenses or distributed to investors as a return on their investment. Most syndications will distribute any available cash flow either monthly or quarterly.
Depending on the type of project and its performance, the cash flow distributed may be a lot or little over any given period of time. In fact, for certain types of projects, like a heavy renovation or new construction, there may be no cash flow for the first several months or years after the property is acquired. Over time, cash flow will typically increase.
Total returns
Total returns reflect all the money distributed to investors over the course of the investment, including the cash flow, but it also includes any additional returns generated from a refinance, sale of the property, or any other significant event that generates income.
The bulk of the returns outside of cash flow will generally come several years after the investment is made. Again, this is when the property is refinanced and cash can be taken out of the deal, or when the property is sold and the investment is completed.
In fact, as an LP, you should expect that the vast majority of the returns you receive from your investment will come at the end of the project, when the property is sold and income from the sale is distributed.
Tax benefits
Finally, many real estate syndications will provide tax benefits to their LPs in the form of depreciation. Depreciation is a “paper loss” that for some investors can be used to offset other income they are generating from their investments, or even their ordinary income.
Because this discussion is both complicated and highly specific to each investor’s personal financial situation, we won’t be talking about it any further here. But be aware that many syndications will provide tax benefits, and if you are in a position to benefit from those, this is an additional consideration when looking at potential investments.
The Proforma
When reviewing a syndication, you should expect to receive what is called a “proforma.” This is an overview of the projected financial performance of the investment on an annual basis. While every syndication will provide this information in a different format, here is an example of what this proforma might look like:
For this particular proforma, we see the projected returns on a hypothetical $100,000 investment. The operators project a sale after five years, and have provided a detailed breakdown of the cash flow and total returns expected from the project on an annual basis.
Looking at the proforma, we see that in the first year of investment, if we were to invest $100,000, we should expect to receive about $5,124 in distributions. That increases to $6,899 in year two, and continues to increase all the way through year five, where we can expect $9,483 in distributions from the operation of the property.
Additionally, we can see that the investment projects that, in year five, there will be a sale of the property, resulting in additional proceeds of $58,926 and the return of our $100,000 in capital invested.
Over the course of the entire $100,000 investment, we can expect to receive $37,852 in cash flow and $58,926 in additional proceeds, plus our original $100,000 investment back, for a total return of $196,778 over the five-year investment period.
In addition to providing this projected return amounts, the syndication will also provide a set of metrics that encapsulate these returns, providing additional insight into the projected return on investment from this deal.
Syndication Proforma Return Metrics
Let’s discuss the most common return metrics you should expect to see from a syndication proforma, what they mean, and how they are calculated. While you very well may see others, there are two common cash flow metrics and three common total return metrics that you should expect as part of the syndication proforma.
| Cash Flow Metrics | Total Return Metrics |
| Year 1 cash-on-cash return (Year 1 COC) | Equity multiple (EM) |
| Average cash-on-cash return (Average COC) | Average annual return (AAR) |
| Internal rate of return (IRR) |
Remember, the cash flow received from a syndication investment is based on the actual performance of the property. Some months or quarters, a property may see strong income and/or low expenses, and cash flow may be higher; other months or quarters, a property may struggle or experience surprises, and cash flow may be lower.
Both cash flow metrics are based on a concept called cash-on-cash return (COC). COC provides a concise measurement of how much annual cash flow an investor can expect for each dollar invested into a deal. For investors whose primary focus is generating cash flow, COC is a critical metric.
Most syndication proformas will provide two cash flow metrics based on COC:
- Year 1 COC
- Average COC
Cash flow metric 1: Year 1 cash-on-cash return (Year 1 COC)
With many syndications, the cash flow available to be distributed to investors in the first year of the investment will be considerably less than in subsequent years, because the first year of ownership is often the least profitable.
Operators are doing a lot of renovations, which means empty units and vacancies are likely to be higher than what’s typical. Rents are likely still below the market rate. And the first year of ownership tends to see a lot of turnover in tenants.
For all these reasons, income tends to be lower in the first year, and expenses tend to be higher in the first year than in future years. And this results in less profit and less cash distributed to investors.
So investors are often very interested in the level of cash flow in the first year, as it sets the bar for what to expect in future years. The Year 1 COC indicates the percentage of the initial investment that is projected to be returned as profits in the first year of the investment, and is calculated as follows:
Year 1 COC = Year 1 Cash Flow / Initial Investment
As an example, let’s take a look at our proforma to determine what the Year 1 COC would be for this particular deal.
The cash flow in year one is projected to be $5,124 on an initial investment of $100,000, so the Year 1 COC would be:
Year 1 COC = $5,124 / 100,000
Year 1 COC = 5.12%
In other words, for every $1 invested into this deal, the investor should expect about $0.05 to be returned in the first year.
If you are investing with the need or anticipation of cash flow, you can use this metric to compare to the return you might receive from another cash-flowing investment.
Cash flow metric 2: Average cash-on-cash return (average COC)
While the first year of cash flow may be lower than average, over subsequent years, cash flow will generally increase. As the property is stabilized, rents are increased, and expenses are optimized, the property will often start to generate more distributable income year after year.
Many investors want to get an idea of how much that cash flow will increase over the years, and—on average—what they can expect the annual cash flow to be over the entire duration of the investment.
Average COC provides this. It takes the cash-on-cash return for each year of the investment, and averages them to indicate what the investor can expect in terms of cash flow in a typical year:
Average COC = (Year 1 COC + Year 2 COC + … + Year N COC) / N
N is the number of years of investment
To go back to our example, we’ve already calculated our Year 1 COC to be 5.12%. We can do the same for Year 2 ($6,899 / $100,000 = 6.90%), and all additional years through Year 5.
Therefore, the average COC for this investment would be:
Average COC = (5.12% + 6.90% + 8.13% + 8.22% + 9.48%) / 5
Average COC = 37.85% / 5
Average COC = 7.57%
In other words, over the five years of this investment, a passive investor should expect to receive on average a little more than 7.5% of their initial investment back each year.
Note that average COC is just that—an average. And it’s quite possible that there won’t be a single year when the actual return is close to the average. It’s also possible that some years may be significantly more or less than the average.
In addition to the cash flow metrics, every syndication will also provide metrics indicating the overall financial performance expectations from the investment, inclusive of all the cash flow, plus all the additional income expected to be generated. Again, the bulk of this additional income will likely come from a refinance and/or sale of the property.
The three most common proforma metrics for total returns include:
- Equity multiple (EM)
- Average annual return (AAR)
- Internal rate of return (IRR)
Total return metric 1: Equity multiple (EM)
The simplest measure of the performance of a syndication is equity multiple (EM). EM gives us an indication of how many times our investment has increased, inclusive of all cash flow and profits generated throughout the hold period.
As an example, an EM of 2 would indicate that your investment doubled over the course of the deal. Let’s say you were to invest $100,000, and over the course of the investment—between cash flow and sale of the property—you were returned your initial $100,000, plus another $100,000. That would be a total return of $200,000. You have doubled your investment and would have an EM of 2.
Tripling your investment would result in an EM of 3. And if your investment didn’t generate any returns other than you receiving that initial investment back, your EM would be 1.
The formula for EM is as follows:
EM = Ending value / starting value
For this example, the ending value is $196,778 (the total amount received back from the investment) on a starting investment of $100,000.
Your EM would be:
EM = $196,778 / $100,000
EM = 1.97
In other words, if everything goes as planned, you should expect to double your money over the five-year hold period of the investment.
Note that EM doesn’t necessarily imply a certain time period. For that reason, EM isn’t always very useful. A project expected to take 10 years with an EM of 2 isn’t going to be nearly as lucrative as a project expected to take five years with the same EM.
Additionally, it can be difficult to compare two deals with different hold periods simply by comparing their EMs.
Total return metric 2: Average annual return (AAR)
We talked about average COC indicating the average cash flow the investor could expect to generate in a typical year during the hold of the property. But again, the average COC only includes the income generated through cash flow from property operations.
If you want an idea of the average return you can receive in a given year from all sources of income (cash flow, profits from refinance, profits from sale, etc.), we use the AAR metric:
AAR = ((ending value / starting value ) – 1) / N,
N is the number of years of investment
Going back to our example, the ending value is $196,778, the starting value is $100,000, and the hold time is five years.
AAR = (($196,778 / $100,000) – 1) / 5
AAR = 0.97 / 5
AAR = 19.36%
Over the course of the five-year investment, an investor could expect just less than a 20% return on average per year.
The important thing to keep in mind with AAR is that the bulk of the profits from a typical syndication won’t come until the end of the project (when the property is sold), so in most years other than the final year, the actual return will be lower than the AAR indicates. That said, if everything goes as planned, the final year of the investment—when the property is sold—is often going to generate an average return well above the AAR.
Total return metric 3: Internal rate of return (IRR)
The one factor that EM and AAR don’t take into account when measuring total return is when money goes into the deal and when it comes out of the deal.
Imagine a situation where you invest $100,000 into a deal that last five years. In one scenario, you receive cash flow of $20,000 per year, with no additional income at the end of the project. In a second scenario, you receive no cash flow during the entire five-year period, but you receive $100,000 in profit at sale.
With both scenarios, you have received $100,000 in profit on your $100,000 investment. That’s an EM of 2 and an AAR of 20%.
But would we consider the two scenarios to be equal? Probably not. In the first scenario, we are receiving money much sooner than in the second scenario. And for anyone familiar with the concept of time value of money, we know that money we earn sooner is worth more than money we get later.
So how do we take the timing of when money goes in and comes out into account? Using the IRR metric. IRR tells us the rate at which our investment compounds throughout the project, as it assumes that any money that comes back to us before the end of the project (for example, from cash flow) can be reinvested and earn additional return.
While calculating IRR isn’t something that can easily be done by hand, it’s not too difficult using a spreadsheet or financial calculator.
Taking into account all the money going into the deal (just the $100,000 investment in this example) and all the money coming out of the deal (the regular cash flow, plus the sale proceeds and return of capital at the end), and putting that information into an IRR calculator, we would find that the IRR for this deal would be:
IRR = 15.85%
What this tells us is that your initial $100,000 investment, along with the reinvestment of any cash flow or other income you receive from the property during the hold period, will compound at a rate of nearly 16% on an annual basis from the beginning of the investment until the end.
Final Thoughts
Here is the proforma summary of this entire deal:
