If you’re interested in investing in real estate syndications, it’s important to know how these deals work, how they distribute cash flow, and how they split the equity. But how do you know if the distribution model properly rewards the investors? And what incentives drive the decisions in the operation of the syndication?
We’ll try to answer those questions so you feel confident investing in real estate syndications.
This blog post will dive into the three most common syndication models: debt investment, straight split, and the waterfall model. In addition, we will look at different hybrid options that utilize multiple of these syndication models
We will discuss the pros and cons of each model and help you decide which one is right for you.
Once you’re ready to invest, check out our resource on the best real estate syndications.
What Is A Real Estate Syndication?
Before we dive into the structures of real estate syndications, let’s quickly define what a real estate syndication actually is.
A real estate syndication is a business arrangement where multiple investors pool their money to invest in a real estate project. The syndication is led by an experienced real estate developer or operator who puts up a portion of the capital and manages the investment.
The syndication model allows smaller investors to get involved in larger real estate projects that they wouldn’t be able to do on their own. It also allows the operator to raise more capital than they could with just their own money.
Real estate syndications are typically structured as either debt investments or equity investments. Debt syndications provide financing for the real estate project and receive interest payments and principal payback from the project’s cash flow. Equity syndications invest in the ownership of the real estate project and receive a portion of the profits from the sale or cash flow of the property.
Want to learn more? Check out our article on multifamily real estate syndications.
Who Is Involved In Real Estate Syndications?
The real estate syndicate has two main actors the General Partners, often known as the “real estate syndicator” or the “sponsor” and the Limited Partners, commonly known as passive investors.
The company offering the real estate syndication deal will provide the general partner or general partners depending on the size of the deal.
The limited partners will provide the capital investment. In many syndications, the initial funds are provided through short-term bridge financing so the sponsor doesn’t have to coordinate collecting the funds from the limited partners. After the deal closes, the sponsor sells shares of the investment to the limited partners and pays off the bridge loan.
How Do Real Estate Syndications Make Money?
Real estate syndications make money in two primary ways. First, through cash flow, and secondly through an increase in equity.
Syndications distribute free cash flow to investors regularly. Typically this is distributed monthly or quarterly depending on the operating agreement of the syndication. Cash flow distribution is great for investors looking to supplement or fully live off their investments.
Equity distributions, on the other hand, happen only a few times throughout the life of the syndication. The two events that trigger equity distributions are refinancing (specifically cash-out refinancing) or the sale of the property. Investors will often get a large payment for these distributions, but can’t rely on them to pay their bills.
These two types of distributions are classified differently for tax purposes. Cash flow isn’t directly taxed, rather net operating income minus loan interest and depreciation is viewed as business income. On the other hand, the sale of the property is viewed as capital gains.
What Do Real Estate Syndications Invest In?
Real estate syndications can invest in a wide variety of real estate assets. The most common type of investment is multifamily apartments, but syndications can also invest in office buildings, retail centers, storage units, hotels, and even land development projects.
The important thing to remember is that each syndication is different. You need to do your own due diligence to understand what you’re investing in and how it fits into your overall investment strategy.
Legal Structures Of Real Estate Syndications
The most common business structure used in real estate syndication is the Limited Liability Company (LLC). This structure is chosen for a variety of reasons, primarily due to the flow-through income distribution. The LLC structure allows a group of individual investors to pool their money and gain access to larger real estate investments like apartment buildings that are out of reach for most investors.
The real estate syndication LLC has at least two (but sometimes more) classes of investors. The general partner is the managing member of the LLC and is often referred to as the deal sponsor or real estate syndicator.
Each non-managing member is a limited partner whose sole involvement is to invest capital and receive equity and cash distributions for their investment. The limited partners are strictly passive investors.
Financial Real Estate Syndication Structures
Now that we’ve answered some of the basic questions about real estate syndications, let’s dive into the different compensation structures that syndications can take.
The two most common structures are straight equity and the waterfall model, but there are other models as well.
Straight Split
The straight split syndication structure is the most simple. In this model, the sponsor and the investors each get a predetermined percentage of ownership in the project. In this model, both the equity and the profits are split based on the percentage ownership.
The percentage ownership isn’t solely based on the amount invested. Because the general partner will be doing all of the work acquiring and managing the real estate investment, they may ask for a larger ownership share. For example, the sponsor may take a 30% ownership share while investing only 10% of the capital.
Waterfall Model
The waterfall model is more complex than the straight split because it awards differing amounts of profit to the partners depending on the profit levels achieved. The waterfall is used primarily with regard to the distribution of cash flow whereas the equity split is most commonly determined at the start of the project.
Typically in a waterfall model, the passive investors are granted preferred returns of the first 6-8% of the profits. When the profit exceeds 8%, the general partner will start to collect a share of the remaining profits. This may be anywhere from 20% to 50% or more.
There are also waterfall agreements with multiple of these profit breakpoints. For instance, the limited partners may receive preferred returns on the first 6%, then receive 80% of the returns from 6-10%, and finally 50% of the returns above 10%.
One big advantage of the waterfall structure is it incentivizes the real estate syndicator to achieve high levels of returns.
If you want to learn more, check out our full guide to the waterfall model in real estate investing.
Debt Investment
Beyond splitting equity and profits, a real estate syndication may bring on investors using debt. In this type of real estate syndication structure, the investors lend money to the syndication with the expectation that it will be paid back in full with interest. Debt investors do not share in the equity or profits of the real estate syndication deal.
Syndications use debt investments for a variety of reasons, primarily for development deals where there are no expected profits for some time period until the development is completed.
Debt investments can also be used as a way to bring non-accredited investors into a real estate syndication. The SEC requires equity investors to be accredited investors, but debt investors can be non-accredited under the proper real estate syndication structure.
Hybrid Model
Now that we have examined the different real estate syndication structures, let’s look at a hybrid deal structure. Most real estate syndications actually use a hybrid approach to differentiate returns from equity and cash flow.
What does this mean?
In general, real estate syndications use a straight split of equity in combination with a waterfall structure with a preferred return for cash flow distribution.
This hybrid structure allows the syndication to provide regular ongoing passive income for the limited partners while also rewarding and incentivizing the general partner for performance.
In addition, a real estate syndication might choose to return the initial investment back to the passive investors through equity returns before splitting the equity with the general partners. For example, if the passive investors provided $1,000,000 for the syndication, and the real estate asset gained $1,500,000 in equity, then the first $1,000,000 would be returned to the passive investors. After that, the remaining $500,000 would be distributed based on equity share.
The Capital Stack
Since there are different types or classes of investors in a real estate syndication, we should look at the priorities these investors are given for their returns. This priority is called the Capital Stack.
The purpose of the Capital Stack is to determine the order in which the different investors get paid. In the Capital Stack, debt investment gets priority over equity investment. This makes sense that the syndication would be responsible to pay off any liabilities before rewarding the equity investors.
The Capital Stack matters most when distributing equity returns either through refinancing or the sale of the property.
The order of the Capital Stack is typically as follows:
- Debt Investment whether it is secured or unsecured. If the syndication offers both secured and unsecured debt, then the secured debt takes priority over the unsecured debt investment.
- Preferred Equity Investment is distributed based on the equity share in the real estate syndication. This class of investors earn a preferred return and own an equity share. This is the most common type of passive investor in a real estate syndication. Often, there is a guarantee that the preferred investor’s capital will be returned in full before the final equity split.
- Simple Equity Investment has the lowest priority but often has the highest rewards. The general partner in a real estate syndication is commonly a simple equity investor. They are granted a higher amount of equity for less investment, but at the same time must put in the work to manage the asset.
Fee Structures
Every type of investment has some sort of fees whether you pay them directly or indirectly. Real estate syndications are no different.
Most fees charged by the real estate syndicator are listed as expenses of the property. Because they are considered expenses, they take the first priority before any returns are distributed.
Let’s take a look at the various fees you’ll encounter in almost any real estate syndication.
Acquisition Fee
The first fee a real estate investor will encounter is the acquisition fee. This is charged as a way to either reward the general partners with a “finders fee” or to repay any capital the general partners had to put forward for legal expenses, earnest money, or other expenses.
Asset Management Fee
After purchasing the investment property, the general partners need to expend time and effort to manage the asset. To compensate them, an asset management fee is typically incurred. This fee is listed as an expense on the property’s income sheet every month.
Refinance Fee
If the syndication refinances the property, typically through a cash-out refinance, the sponsor will often charge a refinance fee based on the amount of money taken out of the property’s equity.
Disposition Fee
Finally, when the real estate syndication sells the property, the syndicator may charge a disposition fee. This is to compensate the syndicator for their time and effort in finding a buyer, negotiating the sale, and managing the closing process.
As you can see, there are many different fees associated with real estate syndications. It’s important to be aware of these fees so that you can understand how they will impact your investment.
Understanding Incentives
Now that we’ve covered the different compensation structures and fees in a real estate syndication, let’s take a quick note on incentives.
The general partners are incentivized based on their compensation. They’re human just like the rest of us. So, it’s important to examine the structure of the deal from their perspective and ensure their incentives align with the performance of the asset.
This is one reason the waterfall model is so great. The more free cash the property generates, the more reward the syndicator gets.
Likewise, fees can be incentives for the syndicators as well. You will need to ask yourself how the syndicator makes money on the deal. Are they going to collect a large fee every time the property is refinanced or are they incentivized to quickly sell?
FAQs
The hybrid model that combines a straight equity split with a waterfall model for free cash distribution has many advantages for passive real estate investors. This model provides regular, reliable passive income along with long-term appreciation.
Most real estate syndications use the limited liability company structure, but some are structured as a limited partnership. There are many financial and legal considerations in the business structure, and the most efficient allows for pass-through treatment of business income.
The syndication model allows investors to join together and raise capital to invest in larger asset classes like a shopping mall or apartment building or even to invest in multiple properties. A syndication often has one general partner who manages the asset and a pool of other passive investors.
Summary
If you’re considering investing in a real estate syndication, it’s important to understand the different real estate syndication structures so you know how the performance of the asset will benefit you.
From straight equity splits to a waterfall structure, there are many different ways to structure a real estate investment. Knowing how you’ll receive distributions will help your financial planning.
Do you have any questions about investing in real estate syndications? Let us know in the comments.