Return OF Capital v Return ON Capital Attorney Explains Which One Violates Securities Laws (Ep 50)

So we’re gonna talk about four things today. The difference obviously between return of capital and return on capital, which I like to call return on investment. We’re gonna talk about the, what I believe many of the mistakes that syndicators or really securities violations that syndicators are making when they’re doing return of capitals. We’re gonna talk about passive investors and what they need to be aware of when they’re dealing with returns of capital. And then we’ll talk a little bit about the tax ramifications of that. And of course, we’ll also open it up to Q&A. So if you’ve got questions, please drop them in the comments. So let’s start with return on capital, return on investments. Obviously, this is more of the most common way to do it. And I think the easiest way to explain this is through examples. So let’s just assume that you are a passive investor, you make $100,000 investment, and let’s just say that you’re getting, in year one, you get $10,000, a 10% cash on cash return. You are still, if it’s a return on investment, you get the $10,000 and they still owe you $100,000, right? They still owe you the $100,000. If in the second year, they give you another $10,000, great. Now you’ve made $20,000 on the deal, but they still owe you $100,000. And in the third year, if they do the same thing, they gave you another, maybe the third year isn’t as good and they only give you $8,000. Well, now they owe you, you’ve made $28,000 and they still owe you that $100,000. And that becomes really, really important when we look at the exits. And that’s where I think the passive investors need to pay attention to. So that’s what, so the return on investment is, meaning you’re getting paid, but they still owe you whatever that initial capital contribution is. Now, most of the time return of capital, what that really means is just when they return the money, they’re actually just giving you your money back or part of your money back. They’re not actually giving you a return, sort of a cash on cash return. That generally happens in our world when there’s a refinance, right? So same example, you put in a hundred grand, let’s see in year one, same thing, you get $10,000. They still owe you $100,000, great. Year two, they give you another 10,000, great. They still owe you $100,000, but the sponsor did such a great job that they’re able to do a cash out refinance and they’re able to return half of your money back, right? $50,000 comes back because of all the value they’ve added, the cash out refinance, they return half of that money to you. That’s gonna be a return of capital. And now instead of owing you $100,000, they’re gonna owe you $50,000, right? That makes general sense. What some syndicators do, and we have a lot of clients who do this, by the way, this is not something that’s anything wrong with this, but a lot of clients decide that, hey, the distributions that we’re gonna make on a quarterly basis, we’re gonna count those distributions as a return of capital, right? And that’s super important because now when you invest that $100,000 and they give you $10,000, well, now they owe you $90,000. They went from $100,000, they’ve returned $10,000 of your own money, go down to 90. If in year two, they give you another $100,000, I’m sorry, another $10,000 as a return, it’s just return of capital. So now they owe you $80,000. And in year three, if they give you $8,000, great, you’ve gotten 28,000, but that’s just a return of your own money. And they now owe you $72,000. And I actually forgot here, but I actually had a nice little sweet little spreadsheet here that I was gonna show you guys, sort of the two examples. I hope you guys can see that. But so here’s the return. So you’re getting the cash here on the return on investment, but the amount that they owe you remains the same. It’s still $100,000. But when they do a return of capital, every time they give you a quarterly distribution, your, what they owe you starts to come down. So instead of 100, 90, 80, 72. And this, like I mentioned, is really, really important when it comes to passive investors, because generally speaking on the backend, generally they have to return your capital first. And so on the backend, you’re gonna see that they are giving you $100,000 first here on the return on investment, but return of capital, they’re only gonna give you 72, but I’m getting ahead of myself. So what’s the biggest issue? What’s the big deal with this return of capital and return on investment when it comes to the syndication world, specifically for sponsors? Let’s talk about sponsors first, and then let’s go to the third one, which is passive investors. The biggest issue that I see, which is actually a securities violation, is you cannot call a return of capital cash on cash return, right? You cannot tell an investor in your prospectus, in your OM, in your business plan, or certainly not in the documents, obviously, that that $10,000 that you’re giving them on a quarterly basis is a 10% cash on cash return, because it’s not, it’s you just giving them back their capital, right? And so you can call it a lot of things. You can call it a distribution, you can call it like cashflow either, or sometimes we call it a cashflow distribution, whatever. But a lot of times I see the word cash on cash return. And by the way, I see that, which is even crazier, I see that on the refinances too. But if I look at a spreadsheet from a pro forma, oftentimes I’ll see you’re sort of the cash on cash, great. And then in year three, it shows them getting like an 80% cash on cash return. I’m like, wait, what happened? What’s going on here in year three? And it just, they just did a refill, they’re projecting a refinance and returning 30% of their money, 50%, maybe 70% of the money, which obviously on that particular year, they might be getting $70,000 because some of it is return on investment, some of it is return of capital, but you cannot call that cash on cash. It’s not cash on cash. And you’ve got to be really careful about using that language in your, primarily in your business plan, I think, especially when it comes to the pro forma. Usually on your pro forma, there’s a section below the line that shows what’s the distributions to the investors. And many, and oftentimes it’s called cash on cash, sort of once you do all the math, but if it’s gonna be a return of capital, you cannot do that because that is at best a material misrepresentation, right? And at worst, some people call it a fraudulent representation. That’s up for debate, whether it’s flat out fraud, it’s certainly maybe not intentional fraud, but it’s certainly a misrepresentation. For our purpose, it doesn’t matter. It’s something that A, needs to be disclosed, number one, but more importantly, we don’t want to misrepresent to the investors. For the investors, so if you’re a past investor, which is also applicable for sponsors, so they understand what’s going on, but what’s critical is typically in a syndication, when it’s time to sell, once you’ve paid off your loan and you’ve got all your expenses done, and now there’s a bunch of cash that’s ready to be distributed, typically the investor gets made, quote unquote, whole first before any of the splits happen, right? So 100% of the investor’s money goes back first before they split whatever the 80, 20, 50, 50, whatever the rest of the profits are. And so in my example, let’s go back to my little nifty chart here. In my example on a return on investment, well, let’s just say there’s, I don’t know, it’s hard to say with just one investor, but let’s just say there’s a bunch of money to distribute. Well, first on a return on investment, the investor is gonna get the $100,000 back first, and then whatever’s leftover is gonna be getting, they’re gonna get their pro rata share of maybe 80%, and then the sponsor is gonna get 20. But on this return of capital scenario, because I only owe the investor 72,000, the sponsor only has to give the investor $72,000 back first before they go into their waterfall 80, 20, or 50, 50, or whatever the backend is. So it makes a huge difference for the passive investor, and arguably it kind of shifts the risk to the backend, right, because the real place where the passive investor is making their money, if that’s the structure, is gonna be on the backend. So you kind of push the investor off a little bit on the risk curve. Again, if it’s a refinance, it’s very, very common. In fact, that’s the only way I know that you would do that. On a refinance, what you’re doing is really returning the investor’s capital. It’s really a part of their equity on a refinance. But if you’re doing it out of the cashflow, out of operations, please, if you’re a sponsor, be very, very careful about calling that a cash on cash return, because it makes it seem like it’s, you know, a return on that money when it’s not, it’s just you’re getting your money back. So you wanna be super, super careful about that. And then the last thing, of course, is the tax implication, right? So that’s one of the reasons actually, which is one of the reasons in favor of doing a return of capital on an ongoing basis, is that the investor doesn’t have to pay taxes, obviously, on that $10,000. If you’re giving me $10,000 back every year, and that’s a return of capital, well, then I don’t have to pay any taxes on that because I’m just getting my money back, right? Again, my tax burden might be a little bit heavier on the backend, but at least on the ongoing quarterly cashflow distribution, there’s gonna be no taxes. Now, arguably, especially over the last few years, with bonus appreciation, at least in year one, you’re not paying, and past investors aren’t paying many, if any, taxes anyway, because of the bonus depreciation. So my $100,000 investment, I’m gonna be able to write that off in year one. But now that the bonus depreciation is starting to phase out, this year, as you guys know, it’s only 80%. There is some tax, there’s definitely some tax differences between the return on investment and return of capital. So if you’re a past investor, make sure you’re talking to your tax professional. And if you’re a sponsor, obviously, you wanna be talking to your CPA to understand how the tax treatment goes with that, because it’s different from the capital account. I don’t wanna get into the whole tax thing, but a capital account is so wacky because that gets up and down all the time. But this is what I call, in our documents, we call this an unrecovered capital contribution. We don’t mess around with depreciation and the tax and whatever, but if I put $100,000 into the investment, then that’s your unrecovered capital is 100,000. And if that starts going down because of return of capital, then your unrecovered capital starts to go down. And then on the backend, when I say, all of the money goes to the investors until they have their unreturned capital contributions returned, well, that number is gonna be a little bit lower if you’re doing a return of capital. I know Jared Lutz had a question in the Facebook group. By the way, if you guys wanna part of the Facebook group, I would highly recommend it. It’s forward slash FB group. It’s just the Real Estate Syndicator Facebook community. If you’re getting value to this, please hit that like button, really appreciate that. But Jared, do you wanna ask your question? Cause you had an interesting one. I had it actually for a second and then I forgot. Do you remember what the question was, Jared? So I thought I knew the difference between the return of capital and the return on capital, but where I got super confused is with the infinite return model, which is where you’re taking your capital back. So when is it legal and when is it not? Yeah, so the, great question. So the infinite return model is when the generally it works when you’re doing refinances, right? So the idea is that the sponsor has done such a great job. They’ve added so much value to the property that they’re able to refinance, do a cash out refinance and get enough money off the table to return a hundred percent of capital, right? Make you whole. So if you put in a hundred thousand dollars, the syndicator can give you a hundred thousand dollars back as a result of that cash out refinance. So that is a return of capital. So you have all of your money off the table at that point. And so you’re gonna continue to get distributions. It’s probably gonna be a little bit less than you did before, but you don’t have any money in the deal anymore. They’ve returned all of your capital during that refinance. Now, lately, that’s been a little bit harder to do. And sometimes it may happen over two refinances. So maybe refinance number one, they give the investors 30% back or 40% back. And then a couple of years later, they do a second refinance and that’s when they get everybody off the table, but that’s when the infinite return happens. And by the way, you don’t have to get to the infinite return model. I mean, if you think about it, even if you return 70% of my money, well, now I’m only $30,000 into the deal and my cashflow is still coming up. If you try and figure out what your cash on cash really at that point with only $30,000 as your basis, that spikes pretty high. You might be getting a 20, 30, 40% cash on cash return, but it’s based on the 30,000, not on the 100. And then don’t forget, you can take that money that they give back to you and put it in another deal. So now you start, that’s the beauty of infinite return. You start double dipping, right? You’re still getting cashflow from the original investment, but you’ve got your $100,000 back. You go put that in another syndication or maybe another syndication from the same sponsor because they’ve done such a great job. But now I’m getting 10% of that money again, right? So I’m almost just using $100,000, I’m sort of rinsing, repeating, and using that 100,000 over and over again and getting multiple streams of income on that $100,000 because the sponsor’s doing such a great job that they’re able to return all that money at some point, still hold onto the asset. And it just happens through cash out refinances. The only way that really works well is if you hold on for a long time, right? If you’re buying stuff and selling it after four or five years, which a lot of people have been doing, it’s difficult to do that. But we’ve got clients, Ken McElroy talks about this all the time. He’s got deals that he bought 20 years ago. They just don’t sell because why sell when they can just do a cash out refinance and return a bunch of money to the investor. At this point, the investors keep getting chunks of cash back from those cash out refinances. And they’ve long received their initial capital back 10, 15 years ago. And the property continues to appreciate. So every so often the property goes up, they do a cash out refinance, return money to the investors. Then the property continues to appreciate, they do another cash out. So maybe after every five or six years, you’re doing one of those cash out refinances. And if you’re holding the property for 20 years, well, that’s two, three, four times that you can cycle that money around. So it’s a very powerful strategy. The infant return model is, but that all comes from the return of capital that comes from a refinance of the property. I assume the K-1 is completed differently for return of capital versus return distributions. What K-1 boxes are used for each? Yeah, a hundred percent. Your K-1 is gonna look very different under a return of capital versus return on investment. Which boxes you’re checking, you’re getting really, really technical. I don’t know if any of our resident CPAs that are on the call usually, I don’t know if Jason you’re on here or not, but if there’s a CPA you wanna raise your hand or just jump in, great. But the K-1 is definitely gonna look very, very different. And again, it’s gonna affect your, it’s really affect, it’s interesting, it affects the backend. So when you get that final K-1, that’s where a lot of your basis is going down. A lot of that money is gonna be capital gains, which may be a good thing, maybe a bad thing, but it’s gonna definitely look different. But which boxes you’re gonna check, I’m gonna defer that to Joe. If you’re not a part of, I think you are part of the Facebook group. I would ask that in the Facebook group because we’ve got about three or four great CPAs on there and they’re gonna be happy to answer that. As an LP, once the original capital I invested is returned to me 100% and they refinance again, what is owed to me after that? How is that broken down? So if they’ve already given you a return of all of your money via the return of capital, right? So let’s just hypothetically say they’re doing a return of capital and you put in a hundred thousand and they’ve given all that money back, either through a refinance and they refinance again, then at that point, you’ve got to look at the documents. Typically then they’re just gonna split that money 80, 20, because usually on a refinance, let me just backtrack, usually on a refinance, 100% of any excess cash after you’ve paid the bank and all the fees and all that, but 100% of that money again, goes to the investors first until they’ve been made whole. Now, generally they don’t get made whole. So generally on a refinance, which is not that’s why it’s not great for the sponsor, all of the money goes to the investors to reduce their capital, unrecovered capital contribution. But if it doesn’t get down to zero, the sponsor doesn’t get any money at that point, but it does help the sponsor on the backend because now they only have to give them a little bit of money because of return some of it through the refinance. So once the refinance has already happened, you get all your money back and now you refinance again, for example, then it’s just most likely gonna be the waterfall, the 80, 20 or the 70, 30, or sometimes there’s an incentive for the sponsor where they say, hey, once we get all of your money back or once we’ve hit some kind of a hurdle, maybe the splits are gonna change and now it’s 50, 50 or something more advantageous as a reward for the sponsor. That’s gonna be in your documents. You wanna make sure you’re reviewing not only the PPM, but maybe more importantly, sorry, it’s like a motorcycle, maybe more importantly, the operating agreement on the distribution side. There’s gonna be a section in the operating agreement, which is gonna dictate how the distributions and the waterfall works. And that’s where it’s gonna outline what happens once that unrecovered capital contribution goes down to zero. I have heard of deals where the PPM may not always be disclosed to LPs. Does this sound like standard procedure? Let’s talk about that in general. It is possible. I think we talked about this last week. That doesn’t matter. A PPM isn’t always required. So let’s go back to sort of syndication 101. A private place memorandum is generally required, especially if you’re doing a 506B, but generally required if you have non-accredited investors. If you have accredited investors, you have no obligation actually to give them any information. You get to choose what disclosures you give an accredited investor. However, once you give them a disclosure, then you have an obligation to make sure that disclosure is complete or a statement is complete. So unless you’re just gonna say, hey, Mr. or Mrs. accredited investor, give me $100,000, most likely you’re gonna give them a pro forma or a business plan or something, right? And so that’s then gonna trigger the obligation to make sure those statements are complete. But it is, I’ve never seen it done, but theoretically you could put together a PPM if you’re doing a 506B, give the PPM to the non-accredited investors and not give it to, or give a different document theoretically to accredited investors. Not the best practice, you’ve already gone through the expense of putting together the PPM. And we generally, oh, not generally, we always give the PPM to both the non-accredited and the accredited. But just remember, if you have only accredited or even in a deal, you’re not required to give accredited investors a PPM under Reg D, you get to choose what disclosures you give them, they just have to be complete. So even if you’re not gonna do a PPM, which generally I don’t recommend, there are some scenarios where we’ve done that, where it’s two or three investors and you’ve known the investors for 30 years and you’re super comfortable. And again, they’re all accredited. Maybe we don’t do a full blown PPM, we’re still gonna put some risk factors, some risk disclosures, as an exhibit to the subscription agreement, or maybe we do what we call a PPM light, but that’s only if they’re accredited. So theoretically you could do that, but I don’t know anybody who does, but so that does seem a little, it’s not standard procedure to answer your question directly. It’s not standard operating procedure, but it is possible, I guess. If I’m an investor in an 8% PREF deal, yep, with quarterly returns, and only two quarters out of the four quarters in the year had distributed, does the investor get a total of 8% return during the year or are distributions caught up to 8%? I’m actually wanting, I still wanna do, I’ve been meaning to do a video on the preferred returns with actual examples on a whiteboard or something, but just remember, preferred returns are not guaranteed, right? All it is is a waterfall, which means 100% of the money is gonna go to the passive investor until they hit that 8% in your case. And that’s an annualized number. So if they give you a quarterly return and you’re on pace, but then later on you start falling a little short because the quarter wasn’t as good, it all gets sort of figured out at the end of the year, and they’re supposed to give you all of the money until that 8% gets hit. And if it’s short, that means you’re gonna get less than an 8% return. You might only get a 6% return or a 5% return, and they’re gonna be short. And the question then becomes, what happens with that shortness? That’s the right word. Does it roll over or are you just SOL? Are you just, hey, it was an 8% preferred, but that just meant you got all the money until that 8% got hit. We didn’t have enough money this year to even cover your 8%, so you’re only gonna get 5%, but next year we’re just gonna give you another 8% and we’re gonna start from scratch. Most commonly, syndicators roll that over. So next year, they’re gonna owe you what they missed from this year, and they’re gonna pay you what they owed you from this year, plus the 8%. And sometimes it just, it takes a while to catch up, and sometimes they never catch up and actually just catch up on the backend when they sell. And so if you look at that waterfall, same thing, let’s just talk about that waterfall on the backend. The first thing that’s always gonna happen is 100% of the money is gonna go back to pay and get the investors whole, get all their money back. And then what should happen is 100% of that money should go to the investors until that preferred return has been caught up, if it’s not, if it hasn’t been so far. And then after that, you start doing your splits, whatever they are. But again, always look at the documents because not every deal is the same. And in fact, I would mention to say every deal is slightly different. It’s worded differently and people do deals differently and there’s no right or wrong way of doing it. It just has to be disclosed and it has to be very, very clear. Oh, and that looks like, again, in our documents, you’re gonna see a very fat, sometimes half a page definition of what a preferred return is. And it’ll outline all the scenarios of what happens if you’re short and all that kind of stuff. Assuming everything is disclosed appropriately and the GP allows, can the investor choose how they want to receive payment, return of capital, return on investment? If the answer is yes, then this is potentially smart contract worthy. The answer is, well, let’s just say, generally, no, I’m gonna say no is the standard operating procedure. So the answer is no. It’s, could it be done? I think it can be done if you wanted it to be done. It just complicates the crap out of things, right? But I think the way I, I like to think of myself as pretty creative. So I always try and figure out, if you wanna do something and you come to us, I try not to say, no, you cannot do that. I wanna say, okay, how can we do that? Is it possible? And I wanna find a couple of ways of doing it and then we might advise you, it’s like, I don’t think you should do it, but legally speaking, you could. In this scenario, just off the top of my head, you could theoretically create separate classes of membership units. So instead of having class A investors, class B, the sponsors, you could have class A1, class A2 for the investors. And then if you want the return of capital, then you can go into class A1 and that, the P&L on that one can be treated separately from the P&L of the second one. I haven’t thought about what the pros and cons of that is or whether your CPA will shoot you, but I think you could probably figure it out if you really, really wanted to do it. But I don’t know, with smart contracts, maybe it’s all super easy to do, but generally speaking, I would definitely bring the CPA in to make sure that was kosher, but from a structural standpoint, I think that’s how I would do that if that’s what the client wanted to do. Tracy says, you are an SEC compliance attorney. Did you ever come across PPM misrepresentations in some clauses of the agreement? In the old days, I say the old days, maybe 10, 15 years ago, I did review other people’s PPM for a fee, like a past investor would call me and say, can you review this PPM on an hourly basis? And I would review it. And yeah, we definitely came across not necessarily intentional misrepresentations, but things that didn’t quite make sense or sometimes the PPM language didn’t match the language in the, I mean, just imagine on this particular topic that you’re looking at the PPM and the business plan and it all talks about return on investment and that’s what, cash on cash, and you think you’re getting a return on investment, but the operating agreement says cash return of capital. So now you’ve got a conflict between the PPM and the operating, and the operating is going to govern. So that’s one of the things I encourage people, past investors to do is making sure not only does the documents match what your understanding of the deal is, but maybe more importantly, make sure the two documents match each other. And I get it, they’re fricking dry, long legal documents. I honestly, again, we don’t do it anymore, but it’s not that expensive. I’ve come across lawyers that for five, $600, or maybe $1,000 will review the PPM for you. And that should include sort of a preliminary call with you to find out what you think, your understanding of the deal is, and then a review of the documents, and then a follow-up call with you to say, hey, here are the things that don’t match up with your understanding. And by the way, here’s a couple of, not necessarily red flags, but just, I want you to be aware of this, this, this, this. And then yes, if suddenly there’s something that doesn’t make sense, I used to point that out to them and say, go back to the sponsor and say, look, there’s a discrepancy among your documents, which one governs and let’s fix it. Or, hey, this isn’t very clear. Is this return of capital, return on investment that you can’t tell from the language, ask them to clarify it. And if they don’t, then that’s probably a sign that you probably don’t want to invest in the deal if they’re not willing to clarify some of that language.

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