Real estate syndication deals are like snowflakes. No two deals are exactly the same.
Some deals offer higher potential returns, with a healthy dose of risk, while others are more conservative and are structured with more conservative splits to boot.
That’s why, regardless of the market and the asset class and the sponsor, it’s important to examine the structure of each deal, to ensure that it aligns with your investing goals.
Let’s take a look at two common real estate syndication deal structures. We’ll examine the breakdown of returns in each type, as well as pros and cons.
Deal Structure Example #1: Straight Split
Let’s start with a straight split. This is probably the easiest deal structure to understand. As the name would suggest, this deal structure uses the same split across the board, for all returns – cash flow, as well as any profits from the sale of the asset.
For example, if a deal uses an 80/20 split, that means that eighty percent of all returns (cash flow and profits from the sale) go to limited partner investors. Twenty percent goes to general partners (aka, the deal sponsors).
This is the same, whether there’s $1 or $100,000 in returns. The passive investors always get eighty percent, and the general partners always get twenty percent.
This deal structure can be especially beneficial to passive investors in deals with high returns. More on this in a bit.
Deal Structure Example #2: Preferred Return
Another common real estate syndication deal structure utilizes a preferred return, or “pref.”
The preferred return is the amount that goes directly to investors. For example, if a deal includes an eight percent preferred return, that means that the first eight percent of the returns (cash flow or profits from sale) go directly to the limited partner investors. That is, the investors get one hundred percent of the first eight percent of returns. The general partners only get a piece of the returns if the returns are above eight percent.
Let’s say you invest $100,000 into a deal with an eight percent preferred return. The first year, the returns are eight percent. That means you get the full $8,000, or eight percent of your investment. The general partners don’t get any piece of that.
While this doesn’t guarantee that you will receive the full eight percent in returns, it ensures that you get preferred treatment for the first eight percent of returns. And, it lights a fire under the general partners to ensure that they’re working hard to get those returns above and beyond eight percent.
So what happens once that eight percent threshold is reached?
The next few percentage points worth of returns activates a different split. For example, any returns between eight and fourteen percent, say, might go to a 70/30 split.
On that same $100,000, let’s say the return in year two is now twelve percent. This means you get the same eight percent preferred return as before, or $8,000. In addition, you get seventy percent of the additional four percent of returns. Seventy percent of $4,000 is $2,800, so your total cash-on-cash returns for year two would be $10,800. The general partners would get thirty percent of the $4,000, or $1,200.
Once you hit the fourteen percent threshold, the split may change again, perhaps this time to a 50/50 split. This use of different thresholds or gates is often referred to as a waterfall deal structure.
This higher split to the general partners at this higher threshold is a good thing. It ensures that the general partners’ interests are aligned with investor interests.
If the general partners are only able to return low or modest returns, most of those returns go to the investors. However, if the general partners work hard, as they should, then everyone wins. The investors get their preferred return, plus some extra on top. The higher the returns, the more the general partners get rewarded for their efforts.
So, Which Deal Structure Is Better?
Of course, there’s no single deal structure that reigns supreme above the rest. There are many factors to consider, including risk, opportunity to add value, length of the hold, goals of the investment, and more.
Many investors love the preferred return, as it provides a safety net, of sorts, and is the closest thing to a guaranteed return that you will get in an investment.
However, a preferred return does take a more conservative approach, and, as such, may deliver more conservative returns, depending on the particular asset.
Times When the Preferred Return Is Better
Let’s say an investment returns right around ten percent each year for five years. In this case, which deal structure would be better?
Probably the one with the preferred return, since the majority of those cash-on-cash returns would go to the limited partner investors.
For a $100,000 investment returning ten percent per year, the straight split would give you eighty percent of $10,000, or $8,000.
With a preferred return structure, on the other hand, that same ten percent would give you 100% of $8,000 + 70% of $2,000, or $9,400.
Times When the Straight Split Is Better
However, let’s take a look at when the returns are higher. Specifically, at the sale of the asset.
The straight split can be especially powerful when the profits at the sale are high. For example, on a profit of fifty percent at the sale, a straight split on a $100,000 investment would get you 80% of $50,000, or $40,000.
On the other hand, a preferred return with a waterfall structure would get you 100% of $8,000 + 70% of $6,000 + 50% of $36,000, or $30,200.
It Comes Back to Your Goals
In the end, only you can determine which deal structure works best for you.
If you’re in it more for the ongoing passive income (i.e., cash flow), a deal with a preferred return might work better, as you would likely see greater cash flow distributions during the lifecycle of the project. However, with the waterfall structure, you may potentially see smaller returns at the project exit.
If, on the other hand, you are in it more for the potential appreciation and profits at the sale, and you don’t care as much about the ongoing cash flow distributions, you might seek out a deal with a straight split, for the chance at a larger piece of the pie upon project exit.
For example, if you’re investing with a self-directed IRA account, the straight split might align more with your goals, as you can’t touch that retirement money for a while anyway, so you don’t need the short-term cash flow. If you’re investing with cash, however, and you’re looking to augment your salary, you might place great value on those cash flow distributions.
There is no right or wrong answer, and there’s money to be made through either type of deal structure. But, when in doubt, circle back to your investing goals, and find a deal with a structure that will help you meet those goals.
So there you have it – two common real estate syndication deal structures. One uses a straight split. The other uses a preferred return with a waterfall structure.
There’s no single deal structure that is “best” or that will guarantee you the highest returns.
Rather, it’s important to examine the deal structure and your specific goals and risk tolerance, together with all the other aspects of the deal, including the market, deal sponsor and track record, and business plan.
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