In the post-pandemic landscape of 2023, the economy is undergoing a profound transformation, adapting to the challenges and opportunities that have emerged in the wake of COVID-19. As the world navigates this new normal, one notable aspect has been the rapid increase in interest rates over the past year. This shift has cast a shadow over numerous investment deals that once thrived, giving rise to pressing viability challenges in the current economic terrain. This turbulence has compelled sponsors to confront tough decisions, leading to temporary holds on distributions. In this article, we unravel the intricacies of this economic evolution, exploring the reasons behind sponsors’ decisions to pause distributions.
From dissecting financial indicators like cash flow and declining revenue to navigating market conditions shaped by inflation. We delve into the complex web of factors influencing sponsors. Additionally, we highlight the strategic maneuvers employed by experienced sponsors in capital preservation. An approach aimed at safeguarding the long-term returns envisioned in the original investment plan. As the economic landscape continues to shift, understanding the dynamics behind distribution becomes imperative for stakeholders navigating the complexities of the investment landscape in this transformative post-pandemic era.
What Causes Sponsors to Pause Distributions
Sponsors aiming to uphold the integrity of their asset performance must assess various financial indicators. Factors like cash flow and declining revenue often experience a downturn when leases are not renewed. This is influenced by market factors such as unaffordable rent growth, job losses, and inflation. Another critical indicator is the net operating income, which gauges the financial health of the property. If revenue declines and expenses, including mortgage rates and insurance, rise, it imposes constraints on cash flow, leading to an overall decrease in the property’s financial health.
The third factor to evaluate is bad debt. While every property carries a small percentage of bad debt or unpaid rent, the impact of inflation on renters can result in struggles to pay rent, causing an increase in bad debt and posing challenges to property performance. These factors often manifest during turbulent economic periods, such as recessions, causing sponsors to strategize how to optimize property performance.
Market Conditions
As inflation impacts the economy, the cost of living increases, putting pressure on renters. From essentials like gas, groceries, and clothing, various expenses have risen, while wages for many have remained the same. This puts a strain on maintaining lifestyles committed to with annual rates and year-long leases. Apartment complexes face significant challenges as tenants struggle to meet their lease obligations, posing potential issues.
The pandemic exacerbates the situation, with properties at risk due to the eviction moratorium protecting tenants. Property owners find themselves with tenants not obligated to pay rent, contributing to a higher bad debt ratio. This, in turn, erodes the property’s cash flow as revenue experiences a significant decline.
Capital Preservation
Experienced sponsors understand the need to make tough decisions. The most common strategy to keep the integrity of an investment intact is capital preservation. When investing in income-producing assets ensuring positive cash flow is very important. This means the income exceeds all liabilities, including debt service. When income declines and the property’s performance is in jeopardy the smartest thing any owner can do is create a cash reserve. The best way to create more cash is to halt payments being given to investors, (ie, pause distributions). This approach enables the retention of cash within the asset. It then can be used for necessary expenses in maintaining the business plan. While it may not be the most favorable option for investors, the operator usually makes this choice to uphold the integrity of the long-term returns projected in the original proforma.
The “Catch-Up”
Investor distributions are funded through property cash flow. However, if distributions cease due to factors such as a natural disaster, a pandemic, or the operator accumulating cash reserves for increased resilience in an uncertain economy, the property cash flow may not support both. In such cases, the payments that investors miss are accrued until a capital event, such as a refinance or the sale of the property. This accrual is often referred to as the “catch-up.” The concept is the investor is caught up to the current amount owed from halted distributions after a refinance.
If the capital event is a sale, the funds in the accrual account are disbursed first. Subsequently, each investor receives their original capital back. This is followed by the distribution of profits based on the agreed-upon split between the Limited Partners (LP) and the General Partners (GP).
When Will Distributions Continue
Investors often want to know when they can expect their distributions to return. However, since each property is unique, the response can vary. If distributions are suspended due to bad debt, addressing the issue through measures like increasing occupancy and raising rent could lead to the resumption of distributions. On the other hand, if there is an increase in debt service or the operator needs to bolster financial reserves for the property’s long-term health, distributions may take a capital event such as a refinance or a sale, which takes time.
I’m not getting distributions, should I panic?
While a temporary distribution halt may raise concerns, it is not necessarily a reason to panic. Instead, it should prompt investors to inquire and gain insights into the overall health of the asset. Understanding the reasons behind the pause and obtaining information about the existence of a well-defined plan and timeline is crucial. This approach helps investors discern whether the property is in distress or if there is a clear path toward resolution.
