- Real estate distributions are funds paid to individuals as part of a real estate investment. The exact amount of distributions is dependent upon a number of factors including the rental income generated by the property and the operating expenses – property taxes, insurance, maintenance – incurred.
- Each investor’s share of income from distributions is paid in proportion to their share property ownership.
- Generally, there are two types of distributions, periodic distributions that are paid at regular intervals throughout the investment holding period and lump sum distributions that are typically paid when the property is refinanced and/or sold.
- When working with a private equity firm, distributions are typically paid using a waterfall methodology that is designed to incentivize the private equity form to deliver as high a return as possible. When they do, it is a win/win for both investors and the firm.
- Distributions have tax implications. They are reported on the schedule K-1 and the income is lumped in with other sources of income to determine an investor’s tax liability in a given year.
- For most real estate investors, it is a best practice to work with a CPA to ensure all necessary taxes are paid.
Fundamentally, an individual’s motivation to invest their capital in a risk asset is derived from a desire to earn a return on said investment. In commercial real estate, these returns typically come in the form of distributions paid to investors on a periodic basis.
In this article, we will define what distributions are, how they are calculated, and when they occur in commercial real estate. By the end, readers will have a greater understanding of how distributions work and can use this information as part of their pre-investment due diligence process.
At First National Partners, we pay distributions to investors in all of our deals. The exact amount is dependent on the structure of the deal and the amount of cash available to distribute, which can vary from deal to deal. To learn more about our current investment offerings, click here.
Real Estate Distributions Explained
The definition of a real estate distribution is simple. The calculation is a bit more complex.
The term real estate distributions refers to the funds that are paid to investors on a periodic basis in return for their upfront investment. The amount of money that is available to be paid to investors is highly dependent upon a property’s gross income, operating expenses (like real estate taxes and insurance), and debt service. To put this point in context, the following table is fairly representative of a typical commercial property income statement:
|Line Item Description||Amount|
|Potential Rental Income||$100,000|
|Effective Rental Income||$90,000|
|Gross Operating Income||$105,000|
|Other Operating Expenses||$12,000|
|Net Operating Income||$48,000|
|LESS: Debt Service||$18,000|
|Cash Avail. For Distribution||$30,000|
The final line in the table represents the net income available to distribute to real estate investors. Depending on the structure of the deal, distributions could be paid monthly, quarterly, or annually.
Types of Distributions
Broadly, real estate distributions fall into two categories, periodic and lump sum.
Periodic distributions are those paid to real estate investors at regular intervals. As described above, they could be paid, monthly, quarterly or annually, as outlined in an investment’s offering documents. Investors like periodic distributions because these disbursements provide them with passive income. However, the bulk of real estate gains are not made from periodic distributions, they come from lump sum payments.
Lump Sum Distributions
Lump sum distributions are large, often one-time, payments made to investors. They typically occur when one of two things happens.
In the first instance, a lump sum distribution can be made when a property has increased in value and its debt is refinanced to take cash out of the property. For example, suppose that a property was purchased for $1MM, which included $800M in debt. After 5 years, the asset value has increased to $1.5MM, and the loan balance is $600M. At 80% LTV, a new loan could be obtained for $1.2MM where $600M of the loan proceeds are used to retire the old loan and the other $600M could be distributed to investors in a lump sum payment. This scenario is particularly common in value-add deals.
In the second instance, a lump sum payment can be made when a property is sold for a profit. Using the same example above, assume that the real property was purchased for $1MM with an $800M loan. But, after five years, the loan balance has declined to $600M and the property is sold for its market value of $1.5MM. From the sale proceeds, $600M would be used to pay off the loan balance and the remaining $900M is the final distribution paid to investors.
Private Equity Distributions
The calculation of investor distribution amounts is unique to each deal. In a typical private equity investment, income distributions are calculated using a “waterfall” methodology that is designed to split capital gains and cash flow in a method that is beneficial to both investors and the financial institution managing the transaction. For the purposes of this article, it is important for investors to understand that cash flow splits usually become more favorable for the financial institution as the property’s return grows. For example, a financial institution may invest 10% of the equity needed to close the deal, but they are entitled to receive 40% of the cash flow and profits if they can deliver a return in excess of 12%.
When working with a private equity firm, fiduciary, or any other type of investment sponsor, it is critically important that investors read all offering documents thoroughly. If there are any doubts or questions about the distribution calculation and structure, investors should consult a qualified attorney or CPA to ensure they are comfortable with the opportunity.
Tax Implications of Real Estate Distributions
No discussion of distributions would be complete without mentioning the tax consequences of receiving one.
Most commercial real estate investments are made through a limited liability corporation (LLC). For tax purposes, the LLC is considered to be a “pass through entity” which means that income and expenses pass through it and are categorized as taxable income on each individual investor’s income tax return. This also means that the amount of tax due is dependent upon each individual’s federal tax rate as determined under Internal Revenue Service (IRS) rules.
Contributions to and distributions from the LLC are recorded and reported on the schedule K-1, which is a tax form that is prepared for investors/taxpayers at the end of each tax year. In most cases, distributions are classified as ordinary income and the tax liability associated with them is dependent upon a number of factors including an investor’s: total income, previous tax payments, depreciation taken, trust income, and other investment income in the same calendar year. All of these sources are compiled together to determine each individual’s total tax due.
The key takeaway is this, when an investor receives distributions / real estate income or incurs capital losses as a result of a real estate investment, it makes their tax situation more complex. It is a good idea to work with a CPA to both minimize tax liability and ensure all necessary taxes are paid – including state taxes.
Summary of Real Estate Distributions
Real estate distributions are funds paid to individuals as part of a real estate investment. The exact amount of distributions is dependent upon a number of factors including the rental income generated by the property and the operating expenses (property taxes, insurance, maintenance, etc) incurred.
Each investor’s share of income is calculated in proportion to their share of property ownership.
Generally, there are two types of distributions, periodic distributions that are paid at regular intervals throughout the investment holding period and lump sum distributions that are typically paid when the property is refinanced and/or sold.
When working with a private equity firm, distributions are typically paid using a waterfall methodology that is designed to incentivize the private equity form to deliver as high a return as possible. When they do, it is a win/win for both investors and the firm.
Distributions have tax implications. They are reported on the schedule K-1 and the income is lumped in with other sources of income to determine an investor’s tax liability in a given year.
For most investors, it is a best practice to work with a CPA to ensure all necessary taxes are paid.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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