Updated: Sep 8, 2021
If you invest in real estate, you probably heard the terms “return on capital” and “return of capital,” which are sometimes mistakenly used interchangeably. As a passive investor, fully understanding these concepts and their significance when it comes to returns will help you become a more astute investor and to optimize your investing strategy. In this article, we will break down Return on Capital and Return of Capital, explain why they are both important, and go over all of the key differences and how they impact your return as an investor.
Return on Capital
In the syndication world, Return on Capital is a ratio that measures how well a syndicator turns investors' equity into profits. When you get paid distributions (monthly or quarterly) from the property’s rents and other income (fees, cable contract, etc.), then you get a return on your capital. For example, if you invested $100,000 and received a 6% return annually ($6,000), then your Return on Capital would be 6%. In other words, the Return on Capital is the amount of money that you receive each year as a result of making your initial investment.
Return of Capital
Unlike Return on Capital, Return of Capital happens when an investor receives their original investment back – whether partly or in full. Return of Capital is not considered income or capital gains from the investment, but it reduces your initial investment balance. So, with the $100,000 investment example, if you invested $100,000 and got $6,000 in Y1, then at the beginning of Y2, your investment balance is reduced to $94,000 ($100,000-$6,000). Essentially, Return of Capital refers to the payments that an investor receives which returns a portion of the capital that he or she invested back to him or her. In real estate, it usually takes a number of years until the investor has all of the capital that he or she invested returned to him or her. The source of Return of Capital is usually completed upon refinancing or sale, and not from the property’s income.
Why Does It Matter To Know The Difference?
Knowing the difference between Return on Capital and Return of Capital is important because Return on Capital lets you know what annual returns you can expect for your initial investment and Return of Capital lets you know the rate at which your initial investment can be recouped. Good real estate investors need to fully understand both of these figures before investing in a particular property. Once they do understand these figures, it helps them to decide whether or not a particular property will make for a good real estate investment.
Distributions to Investors
When investors are being paid their distributions, it is important for them to know whether they are being paid Return on Capital or Return of Capital. It’s important because if your syndicator pays you distributions based on Return of Capital, then you will get lower returns each year, as your investment balance will shrink over time. Let’s look at our previous example. Say you invested $100,000 in two syndications with identical 6% cash-on-cash return every year from the property’s income. If your syndicator is using the Return on Capital, then you will get paid $6,000 every year (6% of $100,000). However, if the syndicator is using the Return of Capital method, then in Y1 you will get 6%, but in Y2, the 6% will be calculated based on $94,000 (since the first $6,000 paid to you reduced your original investment from $100,000 to $94,000). Hence, in Y2 you will get paid only $5,640 (6% of $94,000), and in Y3 only $5,302 (6% of $88,360).
Using the Return of Capital to calculate returns from the property’s income will also artificially generate a higher IRR when the property is being sold since by the time it’s being sold, your pro-rata share of the sales proceeds is calculated based on a much lower investment than your original $100,000.
Whenever we pay distributions to my investors from the property’s income, I’m recording it as a Return on Capital. This is so that the investors are always being paid their percentage based on their original investment. For example, if an investor’s initial investment was $100,000, I would pay them 6% based on the $100,000 every year. When distributions are paid this way, the dollar value of the investor’s distributions remains consistent every year. As a bonus, we will also keep paying the projected return on the initial investment even after we refinance, meaning, even when the industry standard is to lower the initial investment when you refinance, we still peg the 6% return to the original investment, which is a huge perk to our investors.
Key Tax Differences Between Return on Capital and Return of Capital
The ways that Return on Capital and Return of Capital are taxed are very different. Return of Capital does not include gains or losses. It is similar to getting your money back, so, it is not considered taxable. This means that you can receive your full investment back from a Return of Capital perspective and not pay taxes on it up to the full dollar amount you put in.
In real estate investing Return on Capital, on the other hand, is considered rental income and is taxed the same way that other normal rental income is taxed for real estate investors. But, even though Return of Capital is not taxable, this is only true until the original investment balance has been paid off.
So, Which is the Better Option for Real Estate Investors?
If you are a passive real estate investor who invests in a syndication, then you can’t choose between Return on Capital and Return of Capital, as the syndicator will make that decision. There are pros and cons to each strategy. For example, with Return of Capital, there are significant tax advantages, but your payouts will mostly go down in value every year.
For Return on Capital, your distribution payments won’t go down over time in most cases, but they will be more heavily taxed. Which method is best for you depends on whether you just want to recoup your investment quickly with the lowest amount of tax possible, or whether you want to create steady cash flow that can last indefinitely for many years.
If it is the latter that you want, then Return on Capital is best for you. If it is the former, then Return of Capital is the better option.
Discussing The Distribution Arrangement With Your Sponsor
Before you enter into any real estate deal, it is crucial that you discuss the distribution arrangement with your syndicator or sponsor. The reason is that you want to make sure that you are comfortable with the distribution arrangement and make sure that it works well for you. Unfortunately, some real estate investors do not take the time to fully understand the distribution for the real estate deal and find themselves disappointed down the line when they realize that it wasn’t exactly what they wanted.
Some investors have higher thresholds for annual return percentages, and others have lower thresholds. You should figure out what your minimum annual desired Return on Capital percentage is before you enter into a deal that has a Return on Capital distribution setup. If you are going to go with a Return of Capital arrangement, you need to be fully aware of the time it will take for the full return of your capital.
Other Considerations for a Real Estate Syndication
In addition to the distribution strategy, there are many other things that real estate investors should consider before deciding to invest or not invest in a particular multifamily property.
The most important factor is the sponsor’s track record and trustworthiness. Vetting the sponsor before investing is more important than the distribution strategy and should be the first step. After all, if you don’t fully trust the person or company that will manage your money – why invest? The sponsor’s track record is also crucial; the importance of the payout method pales in comparison to lack of experience for obvious reasons.
Knowing the difference between Return on Capital and Return of Capital is important for real estate investors. Return on Capital will usually generate higher payouts (assuming that the investment is doing well of course) yet potentially commands higher tax payments, while Return of Capital strategy will result in lower payouts but will provide a tax advantage since you should not pay tax when your initial investment is paid back to you. Once you’ve identified which strategies best serve your goals, vet your sponsor thoroughly, and only consider investments that align with your overall wealth-building goals.
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About the Author
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial