As a passive investor (limited partner) in a real estate syndication deal, you and the other limited partners combine funds to invest in an asset as a group. When investing together in a large commercial property like an apartment complex, you have no management responsibilities. Both the real estate investing (REI) deal and the investment property are managed by the syndication’s general partner (sponsor).
Yet how can you ensure that a real estate syndication investment deal is a good choice for you? When examining a potential investment of this type, one of the most important aspects to understand is the deal structure. The structure of each investment deal will determine how the financial returns are divided.
You need to know what percentage will be issued to you and the other passive investors and what percentage the general partner (of partners) will receive. It is also essential to understand why different real estate syndication investment deals may operate under different structures.
Why There Are Different Real Estate Syndication Structures
No two real estate syndication investment deals are structured exactly alike. While some syndication projects issue greater potential financial returns to investors, they may carry rather heavy degrees of risk. Other syndication property investments that are more conservative in their structures and safer for passive investors offer more conservative percentages of investor returns.
Syndication investment structures are influenced by various factors, including the individual preferences of the general partner{s) or sponsor(s). The general partner’s experience and track record are also influential, as well as the markets in which they are currently investing. Each investment property and the current market cycle also play a part in shaping the structure of a syndication property investment.
Before investing in a syndication deal as a passive investor, it is essential to understand the syndication structure. You want to ensure that the structure suits your own property investing plans, objectives and goals. You also need to know the financial payout percentages for investors and the sponsor. This will help you to determine whether a specific investment project is a good fit for you.
Different Types of Real Estate Syndication Investing Structures
Different real estate syndication investment structures are as follows:
- Straight-Split. This real estate syndication investing structure is the simplest and easiest to understand. This investing deal structure issues the same percentage of profits to everyone involved, both limited partners and the sponsor. All returns, including cash flow and eventual profits from the property’s sale, are evenly split.
If a property deal is structured with an 80/20 split, 80 percent of all financial returns will be issued to the passive investors. Twenty percent will be issued to the sponsor. This percentage will be used for each investment deal, regardless of whether the returns equal $100 or $200,000. This property deal structure can be quite advantageous for limited partners in investment deals that provide high returns.
- Waterfall Structure. Real estate syndication investment deals that use the waterfall structure often issue a preferred (pref) return, which is high in popularity with many investors. Under this structure, when a syndication deal offers a seven percent financial return, the initial seven percent of cash flow or property sale profits is issued to the passive investors. The sponsor only receives a portion of the returns if they equal more than seven percent.
Example of Preferred Returns
If you invest $150,000 in a real estate syndication deal that offers a seven percent preferred return, your financial returns during the first year equal seven percent. As a passive investor, you receive the full seven percent, or $10,500. The sponsor receives no payout at this time.
There is no guarantee that you will be issued the full seven percent in returns. Yet it is guaranteed that you will receive preferential treatment up to the initial seven percent. It also encourages the sponsor to work diligently toward increasing the returns beyond seven percent.
After the Preferred Return is Reached
According to the waterfall structure, the next higher percentage attained after the initial seven percent in the preferred return model may be issued in alignment with a 70/30 split. The limited partners as investors then receive 70 percent of the financial returns while the general partner is issued thirty percent.
After a 14 percent return is reached, the split percentage may change once again. It may then equal a 50/50 split. These different gates, or thresholds, for returns rates are the reason for the name of “waterfall structure.” Under this investment structure, everyone benefits as the performance of the property improves.
Deciding Which REI Syndication Structure Is Better for You
Neither of these two basic syndication deal structures is better than the other for passive investors. There are many different aspects of each investment to review and consider before investing.
These aspects include the level of risk involved, the potential for the property value to increase and the skill and experience of the syndication management and deal sponsor. Also important are the projected lifetime of the investment and the sponsor’s investing goals for the deal.
Numerous passive investors favor the preferred return model. They are inspired by that element of safety that it offers in terms of the initial rate of return for them. Yet the preferred return design assumes a more conservative approach to investing than some investors like. As a result, this investment model may bring more conservative returns on your investment than you would prefer.
When Is the Waterfall Structure Better?
If a syndication property investment returns approximately 10 percent annually for five years, which investing structure will benefit passive investors the most? In this instance, the preferred return model may be better for investors. This is due to the fact that the greater amount of the cash-on-cash financial returns will be issued to the passive investors.
For example, on a $100,000 syndication deal that returns ten percent each year, the straight-split will return seven percent, or $7,000 for you as a passive investor. When using a preferred return design, the same ten percent will bring you a return of 100 percent of $8,000 plus 70 percent of $2,000, which equals $9,400.
When Is the Straight-Split Model Better?
The straight-split investing model can be very attractive if the profits from an investment property sale are high. If the profit equals 50 percent, a straight-split of a $100,000 property investment will yield 80 percent of $50,000 for you as a passive investor, or $40,000.
Yet a preferred return using the waterfall structure would bring you 100 percent of $8,000 plus 70% of $6,000 + 50% of $36,000, or $30,200. When the profit is higher at the sale of the property, the passive investors can benefit from a larger percentage of the total financial return.
Your Investing Goals Can Determine Which Investment Structure Is Best for You
If you engage in syndication property investment deals mainly for ongoing passive income, a syndication that uses a preferred return structure may be best for you. This structure should enable you to receive larger cash flow returns throughout the project’s lifetime. If you invest with a syndicate that uses the waterfall structure, however, you may receive lesser financial returns at the end of the project.
If you prefer a property investment through a syndicate that offers good potential appreciation and attractive profits at the end sale, you may be less concerned about receiving ongoing cash flow payouts. You may prefer an investment with a straight-split design since it offers the possibility of a greater profit in the end.
For instance, if you invest with your self-directed IRA account, a straight-split investing structure may suit your investing goals. Since you will not gain access to the retirement funds until later, you are not overly concerned with receiving short-term cash investment payouts.
Yet if you make your investments with cash, you may be focused on supplementing your current income. In this case, you may be more interested in gaining regular cash flow distributions.
As mentioned earlier, one real estate syndication investing structure is not better than the other. As a passive investor, you can make money with either style of investing structure. When you feel uncertain about choosing a syndication structure, review you investing objectives and ultimate goals. This will help you to make the ideal decision for your own preferences and needs as a passive property investor.
Concluding Thoughts
In summary, there are two main types of real estate syndication structures today. While one operates with a straight-split design, the other makes use of a preferred return according to a waterfall structure.
As a passive investor engaging in real estate syndication investment deals, there are various important aspects to understand and consider. No one structure will guarantee you of receiving the highest rates of financial return. Be sure to examine each deal according to your investing goals and the risk tolerance involved.
Also consider the market and the investing experience and track record of each deal sponsor. In addition, always ensure that you select investments that will promote your major investment objectives and ultimate goals.