Why is My Cash Flow Less Than My Preferred Return?

In private equity investments, the initial cash flows produced are often less than the stated “preferred return” in the investment’s legal documents.  Why is this?  The private equity “J-curve” can help you visualize how and why cash flows do not always meet the preferred returns in the initial years of a private equity investment.  The J-curve, as illustrated below, generally shows how cash flows to investors. Therefore, the investment returns as represented by IRR are driven by heavy investment, or cash outflows, in the early years, followed by higher cash inflows in the later years as the investment produces the desired effects.  As shown in this graph, when the asset is sold, the gain on sale creates a large spike of cash flows to investors after paying back the debt and initial invested equity capital.  The gain on sale is often a major driver of returns in real estate private equity.

The J-Curve:

There are several drivers of the J-curve in private equity real estate.  In the initial years, cash flows are primarily influenced by investment, including the initial purchase of the asset: 

  1. Initial outlays on property maintenance, renovations, upgrades, and other property improvements drag cashflow lower in the initial 2–3 years of the investment.
  2. When a new owner takes over a property, rents cannot be immediately raised because existing leases must be renewed to capture higher rents.
  3. In addition, aesthetic property improvements that may drive higher rents have not been implemented and may take 2–3 years to result in higher rents.
  4. Often, changes in property management and operations drive some short-term lower collections, confusion, and lost revenues or higher expenses.
  5. Changes in property management systems and processes that may improve operations take time to establish and drive lower expenditures and/or higher revenues.

Once the initial business plan is in place and executed, higher revenues drive higher returns in the later years as expenses are held constant or decrease relative to income.

  1. Property improvements, particularly exterior aesthetics and interior renovations, create a more desirable property and drive increased rental activity and higher rents.
  2. Improved property management drives higher collections, lower delinquency, and higher ancillary fees and income.
  3. Green improvements such as low-flow faucets, sub-metering, efficient lighting, solar electricity, and high-efficiency HVAC systems drive lower utility expenditures.
  4. More efficient processes and procedures drive lower expenditures on personnel, maintenance, and other leasing and management activities. 
  5. Once the increased revenues and decreased expenses (or steady expenses relative to revenues) make their way through the profit and loss statement to the net operating income, they drive higher cash flow; in the end, higher income drives a higher sale price that provides the final jump in cash inflows and IRR.

Operating vs Total Cash Flows:

It is important to note that an asset’s operating cash flows and total cash flows are not the same.  Operating cash flows exclude capital expenditures; however, capital expenditures for property improvements in the initial years of an investment drive negative total cash flows.  Compare this concept to installing solar panels on your home.  When you purchase the equipment, your total cash flow is going to decrease dramatically on day one.  However, your income has not changed, and your expenses are still the same for the moment.  Once the solar panels are operating, you expect your electric bill to be much lower, and since your income has not changed, your net income will be higher.  With higher income, you now have more cash to spend.  In addition, you have increased the value of your home.  The concept is the same for private equity real estate.

Preferred Returns:

Preferred returns are paid out of net operating income, which excludes capital expenditures on property improvements.  Therefore, a property can have a positive net operating income but still be cash flow negative with capital improvements factored in.  As a result, it is unlikely that a private equity investment will generate enough cash flow to pay the entire preferred return, if any of it, in the early years.  As capital improvements drive revenues higher, cash inflows increase.  Over time, capital expenditures are completed, and cash outflows decrease.  Now, net operating income grows to an amount larger than the preferred return, and the property begins paying investors their full preferred return while also catching up on accrued preferred returns.  This is called the harvesting period.  During this period, the property is positioned for sale, which will drive the largest increases in cash flows and returns.

At Cira Capital Group, we help busy professionals passively invest in lucrative real estate assets by creating private real estate funds, pooling investors’ capital with our own, and investing with a world-class team of professionals.

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