This is the second part of a two-part series where we take a dive into real estate syndications at an elementary level. Click here for the first part we covered what a syndication is and what you can expect during the life cycle of the investment from the point where the syndicator first notifies you of an offering to the sale of the asset. In this part we will cover the most common ways the two partnerships receive compensation throughout the investment.
But, how do you make money as a limited partner?
There are 4 main methods for an LP to make a profit in a multifamily syndication.
Preferred return: The preferred return is the return offered to the LP investors before the GP can accepts payment and is the main source of cash flow for the LP. Typical preferred returns fall in the range of 6%-10% depending on the market and asset. The higher preferred return can often signify a greater risk in the investment while a lower return usually accompanies a more stable investment. Of every deal is different and should be vetted independent of the next and previous. If the cash flow of the property falls below the preferred return threshold then the LP will receive less than the preferred return amount. When this happens the shortfall will may or may not accrue and be owed to the LP in future distributions, this is laid out in the OA/PPM. If there are profits above the preferred return they will be split between the GP and LP as laid out in the OA/PPM.
Most often the preferred return is a return on capital so is does not reduce the LPs original investment.
Profit split: After the preferred return has been met there will be a threshold where the property is split between the GP and LP at a rate laid out in the OA/PPM. Typical splits can range from 50/50 to 90/10 (LP/GP). The profit split includes cash flows above the preferred return as well as profits from a refinance or sale of the property.
The profit split, unless during a refinance or sale, is generally a return on capital, like the preferred return.
Refinance: When the sponsor refinances into a new loan the LP will typically receive a distribution related to the amount of their original capital investment. A refinance will occur when the syndicator has raised the value of the property by implementing the business plan or when the term of the loan is due.
The refinance is generally a return of capital event which means the amount invested in the syndication is reduced.
Disposition/sale: At the end of the business plan the GP may sell the property which will result in a return of capital and profit split for any amount above the initial equity investment.
How does the deal sponsor make money?
Of course, a syndicator is not donating their time and effort so how do they get compensated? The GP's compensation is derived through two main methods, the profit split, and fees. The structure of the profit split and fees will vary from one operator to another and from one deal to another. Unlike the fees for your investment accounts the fees charged during a syndication should be related to accomplishing certain tasks or hitting certain goals in the business plan. These fees will not be a surprise and must be laid out in the OA/PPM.
Top operators make sure their payment structure is in alignment with the interests of the LP investors. Their compensation should be tied to the performance of the business plan and operation of the property.
Profit split: The total profit of the syndication is split between the LP and GP after the preferred return is distributed to the LP.
Some syndicators have a catch-up clause between the preferred return and the profit split where they receive all the cash flow for a certain percentage range for them to catch up with the preferred return. For example, if the preferred return is 8% and the catch-up is 2.5% then the profit split will kick in when the cash flow reaches 10.5% cash on cash return.
When the business plan has been fulfilled and the property is sold the LP will be returned their initial capital investment, along with any accrued unpaid preferred return when applicable. After the LP has been made whole, and any catch-up distribution to the GP, the profit left undistributed will be split between the LP and GP.
In some deals the GP will be rewarded if the LPs internal rate of return rises above a certain threshold. For example, if the LP/GP profit split is 75/25 and the anticipated LP IRR is 15% the offering could be structured to have the profit split change to 50/50 after the LP IRR hurdle of 15% is reached.
Acquisition fee: The acquisition fee is an up-front one-time fee paid to the GP at closing and can range from 1%-5% of the purchase price depending on the size of the deal and the experience level of the GP. This fee is to compensate the GP for the time put in to get the deal to the closing table.
Guarantor fee: The guarantor fee is an up-front, one-time fee paid to the loan guarantor at closing. The loan guarantor is a member of the GP who signs on and guarantees the loan. The guarantor must meet certain liquidity, net worth and experience requirements laid out by the lender to qualify for financing. If a member of the GP does not meet the lenders requirements, they may bring a third party into the GP for an equity stake in the GP.
If the guarantor is already a member of the GP, the fee can range from 0.5% to 5% of the principle balance of the loan at close dependent on the level of risk in the loan. If the existing GP needs to bring in a third party, they may offer a 10%-30% equity stake in the GP in addition to or in lieu of the one-time fee.
Asset management fee: The asset management fee is an ongoing fee paid to the GP to cover their day to day expenses of overseeing the operations of the property and implementing the business plan. The fee can either be structured on a per unit basis or as a percent of collected income. The range is usually 1%-3% or $200-$300 per unit per year.
The asset management fee is a great place for the GP to demonstrate an alignment of interests with the LP in two ways. First, by structuring it as a percent of the income the compensation is directly tied to the performance of the property. Second, by structuring the asset management fee after the preferred return so the LP receives their preferred return before the GP receives the asset management fee.
Refinance fee: The refinance fee is a one-time fee paid to the GP for the work done during a refinance. The amount typically ranges between 1%-3% of the original loan amount. As another way to show alignment of interests the OA/PPM can be written to state that the refinance fee is only to be paid when a certain threshold of LP capital is returned during a refinance. This can show alignment of interests by ensuring the refinance is in the best interest of both the LP and GP.
Disposition fee: The disposition fee is a one-time fee paid to the GP at the close of the sale of the property. This is typically 1%-3% of the sale price.
Conclusion
Now that you have made it this far you have gone from inquisitive to knowledgeable about passively investing in real estate syndications. We covered who is qualified to invest and the types of offerings available, remember if you are sophisticated and not accredited you can only invest in a 506(b) offering and you need to have a relationship with the sponsor for at least 30 days prior to receiving the offer. Knowing and abiding by this could protect you and them in the future.
You are ready for the next step and start looking for and vetting syndicators. Get references from them and call the references. Check out their previous and current deals to see if their past offerings interest you and above all else get in there and make it happen!
If you have any questions or if there are any topics you would like to see covered please reach out to me at Mack@InfiniteFocusCapital.com
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