Return ON Capital VS. Return OF Capital
Knowing the difference between Return on Capital and Return of Capital is important because it lets you know what annual returns a passive investor can expect on their investment vs the rate at which their initial investment can be returned.
Return of capital, also known as return of equity, occurs when an investor receives a portion of their original investment back that is not considered income or capital gains from the investment. As you receive a return of capital, your initial invested balance is reduced. For example, if you invested $50,000 into a property and got $5000 for year one, your investment balance will be reduced to $45,000. ROC is usually returned upon refinancing or sale and not from the property’s income.
Return on capital is a metric used to turn the investor equity into a profit and is the money received each year as a result of making their initial investment. When an investor is being paid their distributions from the property’s rental and additional income, they are receiving a return on their capital. So if one invested with the same $50,000 initial investment and is receiving an 8% annual return, their return on capital would be 8%.
As a passive investor, it is important to understand whether the distributions are being paid as return of capital vs. return on capital. This will be outlined by the operator syndicating the deal. If distributions are structured as return of capital first, the passive investor will receive lower returns each year because their investment balance is being reduced over time. For example, for the first year, the initial 8% return of capital on the $50,000 would be $4000. However in the second year, the 8% would be based on $46,000 and a return of $3680 and continually decrease over time. If a syndicator structures it as return on capital, investors will be paid their % based on their original $50,000 and returns can stay consistent year-over-year. Investors should discuss with the operators of the deal to identify which strategy best serves their investment goals.