There are generally three private real estate reporting methods managers use to convey the status of an investment: fair market value, tax basis and unreturned capital balance. Fair market value shows the investment’s actual value. Tax basis is necessary for tax reporting and reconciling contributions and distributions. And the unreturned capital balance determines ownership and distribution rights. In this article, I cover what every individual investor should know about these three private real estate reporting methods.
Fair Market Value
Fair Market Value (FMV) is used to understand what an initial investment is now worth. FMV of the investment represents the amount of capital the investor would receive if the property were sold today. At Origin, we calculate the FMV quarterly for each investor so they understand the value of the investment and how it’s performing. For fair market value to be truly useful it needs to be reported on a Net basis, which takes into account all expenses and fees that will be paid to the manager upon sale.
Below is how fair market value is used to convey the performance of a $1 million investment in Origin Fund II:
| Fair Market Value | $1,100,797.75 |
| Distributions to Date | + $508,576.00 |
| Invested Equity | – 1,000,000.00 |
| Gain on Investment | $609,373.75 |
Tax Basis
Tax basis can be found on a K-1, a form issued annually by an investment manager or general partner. Tax basis represents the value of an individual’s investment in a property for Internal Revenue Service tax purposes. This metric matters most when the asset is sold. The higher the tax basis, the lower the taxable gain will be upon sale. For example, a property that sells for $10 million, with a tax basis of $10 million, will not incur any taxes. In contrast, a property that sells for $10 million, with a tax basis of $1 million, will be taxed on a $9 million gain.
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The tax basis starts by taking the original amount invested in the property. This figure is increased when additional contributions are made and when the property produces taxable income. It is reduced when the investor receives distributions and when operating expenses are passed through to the partnership along with depreciation. The K-1’s detailed information about partnership contributions and distributions can be cross-referenced with the investor’s own records.
Arriving at the tax basis number requires hundreds of inputs throughout the year by the accountants and is no easy task. To an investor, tax basis is somewhat meaningless by itself as it does not convey performance. The K-1 does not detail appreciation, the increase in the value of the asset over time, or the investment’s fair market value. For example, the tax basis for a $1 million investor in Origin Fund II as of December 31, 2017 is $814,932.00. Subtracting this number from the fair market value of $1,100,797.50, however, does give the investor an idea of the potential tax liability if the remaining assets were sold.
Unreturned Capital Balance
Some private real estate managers also report the unreturned capital balance on their financial statements for investors. The unreturned capital balance is the investor’s unreturned portion of invested equity, plus the preferred return, which can be viewed as an interest rate on invested capital, but it is not guaranteed. The unreturned capital balance increases when equity is contributed and decreases when cash is distributed.
The unreturned capital balance is typically an internal metric and used only by the manager to determine when they will begin to participate in a larger share of distributions. In nearly all private real estate investments, 100% of all distributions will go to investors until their entire capital account balance is paid down. Once the investor’s capital account has been reduced to zero, the manager will typically receive somewhere between 10% and 50% of all future distributions. For example, the unreturned capital balance of a $1 million investment in Fund II, which has a 9% preferred return, was $780,400 as of December 31, 2017. Here’s how that is calculated:
| Initial Invested Equity | $1,000,000.00 |
| 10% Preferred Return | + $288.975.95 |
| Distribution | – $508,575.95 |
| Unreturned Capital Balance | $780,400.00 |
The unreturned capital balance, like tax basis, does not convey how much the investment is worth or how much money they made or lost. It only explains how much the manager needs to pay the investor before he or she begins to participate in more of the upside in the waterfall calculation. To determine whether or not the investor is likely to receive the next $600,000, the fair market value is used. It’s possible that the fair market value could be $0 or $2 million, even though the unreturned capital balance is $600,000.
Capital balance accounting is usually detailed in the distribution section of a private placement memorandum. It’s good for individuals to familiarize themselves with how it is calculated so they can double check the math of the investment manager when it’s time for them to receive their incentive fee.
Putting it All Together
A $1 million investment in Origin Fund II looks very different when you evaluate the investment using the three different private real estate reporting methods of Fair Market Value, tax basis and unreturned capital balance. The table below shows the actual values under the various private real estate reporting methods for a $1 million investor in Origin Fund II as of December 31, 2017.
| Fair Market Value: | $1,100,797.75 |
| Tax Basis: | $814,932.00 |
| Unreturned Capital Balance: | $780,400.00 |
The fair market value line shows the investor the value of the investment as of December 31, 2017. This is typically referred to when an investor is updating their net worth calculations or personal balance sheet. The tax basis is found on the K-1 document and is for the investor’s accountants. And the unreturned capital balance tells the investor that they will receive at least $780,400 before Origin earns any incentive fee. Plus, in this case, it explains that a large portion of the initial $1 million investment has already been paid back. The preferred return will continue to accrue on the unreturned capital balance.
As you can see, fair market value, tax basis and the unreturned capital account balance are all very different from one another but are meaningful in their own ways and for different audiences. Used together, they can convey useful information, but they can also lead to confusion if one doesn’t understand their nuances.
