Aligned Ventures
12/29/2022
Whether you are new to real estate investing or have already built an extensive portfolio, you’ve likely heard the terms “return of capital” and “return on capital”. While some investors use these terms interchangeably, they describe completely different concepts. Understanding how these concepts differ should help you grow as a real estate investor and learn how to optimize your strategies. In this guide, you’ll find out why both of these terms are important.
What Is Return on Capital?
When it comes to real estate syndication, return on capital is used to measure how effectively a syndicator has converted investor equity into realized profits. When paid distributions are provided from the collection of rents and fees, you’ll receive a return on the capital you invested.
Let’s say that you’ve invested $200,000 and have obtained a 7% annual return. Your annual return amounts to $14,000. In this scenario, your return on capital is 7%. This is a simple measurement that tells you how much you obtain each year from the initial investment.
What Is Return of Capital?
Return of capital occurs when an investor is given their initial investment back. Keep in mind that return of capital applies whether you receive some or all of your original investment. The money you receive as return of capital isn’t viewed as capital gains or income from an investment. Instead, it reduces or eliminates your original investment balance.
With the $200,000 investment example mentioned previously, you will have received a return in the first year of $14,000, which means that your investment balance at the beginning of year two is $186,000.
When you invest in real estate, it typically takes numerous years until you receive all of the capital you initially invested. In most cases, the return of capital occurs when the property is sold or refinance.
Primary Differences Between These Investing Terms
Return of capital and return on capital are taxed differently. As mentioned above, return of capital doesn’t take any losses or gains into account. Since you’ll essentially be getting your money back, these funds won’t be taxed.
When it comes to real estate investing, return on capital is referred to as rental income and will be taxed in the same manner as other rental income you bring in. While return of capital won’t be taxed, this only remains true until your initial investment balance is fully paid off.
Understanding Investor Distributions
As an investor, it’s essential that you know how you’re being paid when you receive your distributions. You can be paid with return of capital or return on capital. In the event that your syndicator provides you with return of capital distributions, your returns will become lower with each passing year since your investment balance is dropping over time.
The previous example can be used here as well. Let’s say that you’ve taken part in two separate syndications with $200,000 investments in each. These syndications could provide you with the same 7% cash-on-cash return each year from the income that the property accrues. If one of your syndicators is using return on capital, you’ll receive $14,000 each year.
If the other syndicator uses the return of capital technique, you’ll receive 7% of $200,000 in year one. In the second year, your returns will be calculated on the remaining $184,000 balance in your investment, which means that your returns will amount to $12,880. In year three, you’ll only earn $11,978.
When the return of capital method is used to calculate your returns, this will generate a considerably higher IRR if the property is currently being sold. By the time it’s sold, your share of the proceeds will be calculated on an investment that’s much lower than the initial $200,000 you put in.
Most syndicators provide their investors with distributions from property income as return on capital, which means that investors will always be paid based on what they put in at the beginning of the deal. When paying distributions in this manner, the money each investor receives should stay the same or increase each year.
Before you enter into a syndication deal, it’s highly recommended that you identify how the syndicator handles refinancing. When a property goes through a refinancing, the initial investment is typically lowered since any equity that has been built up is paid out. However, some syndicators will still peg the return to the initial investments that investors made.
Which Option Should Real Estate Investors Use?
If you engage in passive real estate investing, you won’t have the ability to select between return of capital and return on capital. The syndicator always makes this decision. Each strategy has its own advantages and disadvantages. For instance, return of capital provides investors with considerable tax benefits. On the other hand, payouts will likely drop in value each year.
As for return on capital, the distribution payments you receive should remain the same but will likely be taxed more. The method you prefer largely depends on what you believe is best for your portfolio. One option allows you to recoup the initial investment at a much quicker pace. The other option gives you consistent income that could last for many years.
When you’re taking part in real estate investments of any size, both return on capital and return of capital will be important terms for you to remember in the years to come. Return on capital helps you build your wealth before you eventually exit the deal or the property is sold. Return of capital allows you to avoid paying taxes on your annual returns. Now that you understand how these terms differ, you should be able to determine how distributions will be paid to you for the coming year.
To learn more about how passive real estate syndication investing can work for you click the link below and schedule a call with one of our team members to discuss any additional questions you may have and if were the right fit for you.
