Stop Asking to Be Paid Your Own Money Back
When GPs use reserves to manufacture yield, and why LPs shouldn’t want it
Investors, you’re shooting yourselves in the foot when you demand ongoing distributions from deals that don’t generate enough cash flow to pay them.
Yes, a GP can contort themselves and deposit money into your account every quarter, but that doesn’t mean your returns are improving. In many cases, it’s the opposite.
Today, we’re talking about reserves in real estate private equity - the pros/cons, and why you don’t want to be paid your own money back.
I’ll show you how receiving your own cash actually lowers your returns in real estate equity investments. This applies to both one-off syndicated deals and traditional draw-down real estate funds. (Special note: this doesn’t apply to debt funds, nor RE preferred equity investments where LPs will receive a certain pre-determined IRR).
👉 Evergreen vehicles are a different story. They have other levers to manage cash flow. Below, we’ll look at how one non-traded evergreen fund handles distributions (and asset valuations).
🏗️ Reserves in Real Estate Deals
Reserves are funds set aside to cover expected and unexpected costs over the life of an investment. Think of them as the deal’s cushion: reserves will absorb the impact of renovations, lease-up challenges, or market turbulence.
In principle, reserves are a sign of prudence, when used to de-risk a deal. In practice, they can also be used to mask underperformance or inflate early returns.
To be clear: there’s nothing inherently wrong with deals that don’t generate ongoing cash flow. Plenty of money is made in value-add and development deals on the back end.
The issue arises when investors expect steady distributions from projects that were never designed to produce them (but I’m getting ahead of myself), let’s first talk about types of reserves.
Types of Reserves
Replacement reserves cover periodic repairs or replacement of major building components (think roofs, HVAC systems), which would be difficult to fund from ongoing cash flow. In multifamily and student housing, these are often included above the line (as part of NOI).
Capital expenditure (CapEx) reserves fund renovations or large non-routine repairs. In value-add deals, they can be substantial, covering everything from unit upgrades to exterior improvements. CapEx reserves are usually below the line (excluded from NOI).
Other types of reserves you might encounter:
Operating reserves: cash set aside to stabilize cash flow during lease-up or unexpected vacancies.
Debt service reserves (DSR): lender-required funds set aside to cover loan payments during periods of low income or construction.
Contingency reserves: buffers for cost overruns, delays, etc. Common in development deals.
Tax and insurance reserves (escrows): monthly collections to pay annual property tax and insurance bills.
👍 The Case for Reserves
Reserves play a legitimate (and important!) role in de-risking real estate deals.
Used correctly, they don’t necessarily make a deal more profitable, but they make it less likely to run out of cash (and that protects your capital, LPs!)
Here’s what well-structured reserves can do: