A 5 Percent Distribution Is Not a 5 Percent Return, and the Difference Is Your Own Money

Distribution rates are the headline number in almost every Delaware Statutory Trust offering, and they invite a straightforward comparison. One offering says 5.0 percent, another says 5.5 percent, so the second looks better.

That comparison is only valid if both numbers mean the same thing, and frequently they do not. Part of a distribution can be a return of your own capital rather than income the property earned.

What is return of capital?

A distribution funded by something other than the property's operating cash flow.

Sources can include cash reserves set aside from the original offering proceeds, the portion of the offering not yet deployed, or amounts that exceed what the property actually earned in the period.

Economically, receiving your own money back is not a return. It reduces what remains invested, and you would have had that money anyway.

Why do offerings do it?

Sometimes for legitimate operational reasons. A property being repositioned, in lease up, or with a temporary vacancy may not produce full cash flow in early periods, while the sponsor maintains a steady distribution to investors.

Sometimes because a headline rate attracts investors, and a distribution partly funded from reserves supports a number the property cannot yet sustain.

Both happen, and the offering documents disclose the position. The difficulty is that the disclosure is in the detail, and the rate is on the front page.

How do you tell the difference?

Ask directly: what proportion of the first year distribution is projected to be return of capital rather than operating cash flow?

A sponsor who answers immediately with a figure has been asked before by people who knew what they were doing. Vagueness is itself an answer.

You can also look for the projected operating cash flow, expressed as a percentage of the offering amount. If projected cash flow is 4.2 percent and the distribution is 5.5 percent, the difference is coming from somewhere else.

Why does it matter for tax?

Distributions are not taxed simply because they arrive. Your share of the trust's taxable income is what is reported, and that is often lower than the cash distributed because of depreciation.

Return of capital generally reduces your basis rather than producing income. A lower basis means more gain when the property is eventually sold. The tax is not avoided, it is shifted to the exit.

Because basis also affects how much of any future exchange must be reinvested, the interaction is worth understanding with your CPA rather than treating distributions as simple income.

What should you compare instead of the headline rate?

• ›Projected operating cash flow as a percentage of the total investment
• ›The proportion of distributions funded from reserves in each projected year
• ›Total load, meaning the sponsor, acquisition and offering costs deducted before the money reaches the property
• ›Debt terms, including rate, amortisation and maturity relative to the projected hold
• ›The exit assumption, meaning the price at which the sponsor expects to sell

A 5.0 percent distribution fully covered by operations is a materially better position than 5.5 percent where a fifth is return of capital.

Does this mean return of capital is a warning sign?

Not automatically. A property in a genuine lease up phase, disclosed clearly, with reserves funded for the purpose, can be a reasonable investment. The distribution is simply smoothing an expected pattern.

What deserves caution is an offering where the distribution depends on reserves for several years, where the operating projection never catches up with the distribution, or where the sponsor is reluctant to break the number down.

What questions produce useful answers?

• ›What is the projected operating cash flow in each year of the hold?
• ›What proportion of each year's distribution is return of capital?
• ›How much of the offering is held in reserves, and for what purpose?
• ›Have distributions on your prior offerings ever been reduced or suspended?
• ›What occupancy assumption supports the projection?

What to do first

Before comparing two offerings on their headline rates, ask each sponsor for the operating cash flow projection and the return of capital proportion. Then compare those numbers rather than the advertised ones. If a sponsor will not provide them plainly, that tells you more than the rate does.

Nothing here is tax, legal or investment advice. DST interests are securities offered to accredited investors only through licensed broker dealers and definitive offering documents, and investing involves risk including loss of principal. Projections are not guarantees.