In Part 1 of our series, Passive Investing Made Simple, we discussed a few key concepts related to investing passively in a real estate syndication. If you haven’t read it, it can be found here. In Part 2, we’re going to go over how a typical real estate syndication is structured and summarize what is important to understand as a Limited Partner (LP). If you need a refresher on what an LP is, please revisit Part 1.
How does it work?
Real estate syndications can be a great way to diversify your portfolio and achieve higher, more stable returns when compared to many other investments. A syndicated deal may include a wide variety of investment strategies ranging from value-add apartment communities to ground up development to mobile home parks. While different assets classes may have their own unique benefits and risk levels that should be vetted carefully, it is important to understand how these deals are structured so you know what to look for to streamline your research and make an informed decision.
A typical syndication will have both General Partners (GP, aka active investors) and Limited Partners (LP, aka passive investors). The GP includes the active investors that acquire and manage the investment, while the LP includes the passive investors that supply capital to fund the deal.
Preferred Return
Many times, a syndication will include a preferred return for the LP, meaning that the first portion of profits will go to the LP before any cash flow is distributed to the sponsorship team (or GP). A common preferred return (or pref) is between 6%-8%.
Equity Split
Typically, the LP will own 70%-80% of the equity and the GP will own 20%-30%, but this varies from deal to deal so make sure the structure is clearly defined.
For example, in a syndication with a 7% preferred return and then a 70/30 (LP/GP) split, the LP would receive all of the profits up to a 7% return on their investment. Once the returns exceed that 7%, the profits would then be split with 70% distributed to the LP and 30% to the GP.
Waterfall
The deal structure described above with tiered equity splits is known as a waterfall. Some deals may include multiple thresholds or “waterfalls” that will initiate a further equity variation. This may be related to a metric like IRR or cash on cash return. Let’s pretend the deal above has an additional tier to cross. For example, once the LP IRR exceeds 18%, the equity and distributions are split 50/50. That would look something like this:
- For anything up to a 7% return, 100% of profits go to the limited partners
- Once returns exceed 7%, the equity split becomes 70/30 (LP/GP)
- Once the LP returns exceed an 18% IRR, the equity split becomes 50/50 (LP/GP)
There are two ways to view this as an LP. On one hand, it would be nice to keep your 70% equity without another threshold, especially in a deal that exceeds an 18% IRR! On the other hand, having that additional tier provides an additional incentive for the sponsor to exceed that 18% hurdle to boost their own returns. It provides a closer alignment in goals between the GP and LP.
So how do Limited Partners get paid?
It’s nice to understand the structure and typical equity splits, but now you might be wondering how and when you get paid. This also varies, but typically an LP will receive quarterly or monthly cash flow distributions and larger lump sums after the refinance or sale of the property. The distributions and payouts are based on the deal structure and amount of capital invested in the deal.
How do General Partners get paid?
It may seem that these deals are heavily slanted in favor of the limited partners. So how do the general partners get compensated for all the work that they put in to get these deals done? It’s important to remember that the GP put a lot of time and effort into finding the deal, performing due diligence, closing the property, managing the rehab and maintenance, managing the asset throughout the business plan and eventually refinancing or selling the property. As such, these deals usually include different fees to compensate the GP, or sponsors, for their work. Though a given deal will not typically include all of the fees listed below, the sponsorship fees associated with an investment may include:
- Acquisition Fee (1%-4% of the Purchase Price)
- Asset Management Fee (1%-4% of the Effective Revenue)
- Construction Management Fee (1%-3% of the construction budget)
- Disposition Fee (1%-3% of the sale price)
It should be noted that there are no rules governing how these fees are structured, so it is very important to read through the investor documents thoroughly and ask the sponsor to explain anything that is unclear. I also recommend having a lawyer review the Private Placement Memorandum (PPM) prior to wiring funds if you do decide to invest in a deal. I’ll discuss this process in more detail later in this series.
I hope you’ve enjoyed reading through Part 2 of Passive Investing Made Simple, we hope you will continue through the series. In Part 3, we will discuss what to look for in a sponsor and where to find them.
If you’ve found this helpful, visit https://goldribboninvestments.com/ to learn more about how we help others invest in real estate without having to become a landlord. We commend you for starting your journey to financial freedom. You and your family deserve to live a life that provides unlimited amounts of joy, and real estate is a great vehicle to accompany you down this path. Build a life full of Freedom, Wealth and Impact.
Adam Lacey
Managing Member at Gold Ribbon Investments
