All right.
We're back today.
I want to talk to you about this thing called carried interest.
You may not know what that term is, and that's why I'm doing this video.
You may have seen a lot of talk about carried interest in the news lately,
especially when the Inflation Reduction
Act was being negotiated and passed because that was a provision in there
that they were going to expand and use to create more tax revenue potentially.
Of course, it got taken out last minute.
But the reason I want to cover it is because it comes up
every couple of years again.
It was also in the build back better act for a little bit.
They tried to get something in there back.
When the Tax Cuts and Jobs Act passed.
And this has just been going on for decades.
And they actually did get
a little bit in there back in 2017, because what essentially happened
is that you could have long term capital gains.
So given that, you're probably going to continue hearing about it.
Let's get into what this actually means.
A carried interest is typically or at least one of the attacks on it
is that it's mostly used by private equity firms and hedge funds,
because what they'll do is they'll raise a bunch of equity
and they'll invest it in order to manage the investment.
They'll typically charge a fee based on the assets
under management or in a home or some other kind of criteria.
And typically it's 1 to 2% of the assets under management.
And that means they're just taking that fee.
And the thing is, that really is more covering the costs for them.
It's not really where they make their bread and butter most of the time,
where it really comes in is once an asset performs well and it sells.
And generally, as you know, if you have a stock portfolio,
when you sell a stock, if you've held it for more than a year
or if you own real estate and you hold it for more than a year,
then you actually get preferential tax treatment
because it's a capital gain, a long term capital gain, to be more specific.
So this means that your rate is actually lower on that asset.
So what these companies do is when an asset sells and it was funded
by these equity investors, typically large pension funds or things like that,
then they will take a cut of that profit.
For example, maybe they take 20% of the profit
while because that was from the result of selling a capital asset
that becomes capital gain to the fund managers,
and therefore they're getting preferential tax treatment.
So the idea is that, well, they should pay the same tax rate
as hardworking Americans and not get this special tax break of capital gains.
So backing up a little bit of history, in December
2017, when the Tax Cuts and Jobs Act passed,
they did try to close this loophole a little bit
and they expanded to say, if you have this profits
interest or carried interest where you didn't invest any money,
but you are going to receive the benefit of profits, then you must hold
that interest for at least three years
in order to have long term capital gain.
So that cut down potentially on some of that preferential treatment.
Of course, a lot of assets may be held longer than that
and they'd still get preferential treatment.
We were lucky for real estate that that actually didn't apply for real estate.
So you can typically
you have the same structure when you have a syndication or someone,
a general partner or a sponsor as we like to call them, is raising money.
They typically are doing pretty much
the same exact thing and taking a cut of the profits.
But real estate, you actually don't have to hold
for three years to get that special preferential treatment.
As long as you have a long term hold over one year, you still get that treatment.
Of course, that was something that they were going to potentially
close the loophole on in the Inflation Reduction Act that was passed recently.
But it got taken out at the last minute, luckily for real estate.
So let's get into an example so we can show you exactly how this works.
All right.
We're at the board, so let's go through this quick and easy example.
Just know that I'm keeping this really simple.
A lot of the numbers are just rounded.
Some of the assumptions you may question and say, and
I don't know if that you'd actually get a loan with that interest rate.
I don't care.
This is just to illustrate a point.
Let's say you've got a $60 million deal.
You're buying a $60 million asset.
It's real estate.
I'll just say it. It's an apartment.
Doesn't matter.
And you decide as the sponsor
that you're going to raise 20 million of equity.
So that's your equity capitalization.
And then you're going to get a $40 million loan on the property to acquire it.
So your total capitalization is the 60 million.
Again, keeping it really simple.
We're not figuring out reserves.
We're not figuring out any of that.
We're not going to worry about improvement costs.
Super simple.
Then we're assuming that you've purchased this property at a five
and a half percent cap rate.
Again, big assumption.
Don't look into it too much.
That's not the point.
So if you have a $60 million
purchase at a five and a half percent cap rate, that means you're in a
Y or net operating income is going to be about 3.3 million.
And this is your A.I.
before debt service.
Okay, because your cap rate does not include the debt service.
Next, let's assume that as part of this deal, the sponsors agreed that they're
going to pay the $20 million equity partner partners
a 5% preferred return, meaning that
before the sponsor gets a share in any of the profits,
the investors have to be paid a 5% return on their $20 million equity.
And then after that, 5% preferred return
threshold is accomplished, then they will split the proceeds.
After that, 20% and 80%,
20% going to the sponsor, 80% going to the equity investors.
So that's the makeup of the deal.
So knowing that we have a $60 million purchase and they've bought it
at a five and a half percent cap rate, don't question the cap rate.
That's not the important part.
We're just trying to illustrate how this carried interest works
and why it's important.
And this will also, if you're investing in any kind of syndications,
a lot of them are structured this way with some kind of variety
so that this will help you understand how those deals actually work.
If that's something that you want to invest in,
or if this is something that you're looking at,
you've been in real estate and you want to start raising capital.
This is a potential way that you could start structuring it if you want it.
Essentially, you take your $60 million, times are five and a half percent cap rate
and you get a $3.3 million net operating income or an OAI.
So the know why is before your debt service.
Okay, so we have to come up and we have to figure out
what's our actual cash return from this investment
that we're going to be able to split between the equity partners
and the sponsor, who we're going to assume didn't put any capital in in this case
for simplicity. Okay.
So if we assume a mortgage, which is $40 million
and we say that the interest rate is 3.9%
and it's amortized over 30 years, again, a lot of assumptions don't question it.
You get to essentially $2.3 million of debt service
annually or about $190,000 a year.
This means after you subtract your debt service from your
in a Y of 3.3 million, that you get $1,000,000 net income,
net income after debt service, that is the amount.
But now you have to figure out, does it go to your equity members as a return
or the sponsor as a carried interest
and really a carried interest
can also be referred to as a profits interest.
They're essentially the same thing, just different terms
in order to figure out where this million dollar net income would go,
we have to look at the deal.
And remember, the deal was that the investors will get a 5% return
before the sponsor gets anything.
So $20 million of equity
tends a 5% pref, means there's $1,000,000.
And again, I made a really simple I made the numbers match
because when we go further in the example, it just makes it easier when we do this.
So that means because we have only earned enough
to pay the 5% pref, it's going to all go to the equity members.
And this is actually pretty typical in the first few years
of acquiring an asset because there's generally not enough to pay the sponsor.
Yet that's not really when they make most of their income.
It's really at the end when they sell the asset.
So let's move to that.
So now let's assume it's three years later
and you sell the asset for 70 million.
Okay, well, we know that we have to first pay off our debt.
And again, I'm keeping it super simple.
Okay.
So we know you'd probably have some debt paydown
with your payments every month unless it was interest only.
But we're just going to keep it simple and we're going to assume your principal
balance of a debt was the same as when the asset was acquired.
So we're just going to subtract off
40 million of our proceeds has to get paid first.
Then we're going to say, okay, we still have 20 million of equity
that's sitting in there.
We have to pay those people first.
So when it's all said and done, we have $10 million
left over to figure out where that goes.
And then I'm ignoring any kind of selling costs, things like that.
In this example, we've already had three years pass.
We had $1,000,000 of income each year which went to satisfy the 5% pref
and we're assuming the $70 million sale happens in that third year.
Also.
So if that's the case, we've already satisfied the 5% preferred return
that the equity members have to receive first because of the cash flow.
So that means now we're at the profit split or the carried interest.
So 20%, we said of the 10 million is going to the sponsor.
So the sponsor gets $2 million.
They didn't put any money in, but they get $2 million
because that's the agreed amount they decided to split.
And then the equity members get 8 million, this $10 million gain
because it was an asset, it was real estate used in a trade or business.
It was held for more than one year.
That $10 million is a capital gain.
So when you split the profit of which is capital,
the $2 million that sponsor get is now capital gain,
even though really what they did was they got that profit
because they put the deal together, they managed it, they found
they had the connections, they put the loan together,
maybe they guaranteed the loan, all of these pieces.
This was part of their business,
but because it was a capital asset, they get capital gain treatment.
So that is the carried interest and that's what people are typically upset about,
is why is the sponsor getting that preferential treatment?