Real estate syndication structure basics and what to look for


A real estate syndication is a partnership between a group of investors that combine resources, skills, and capital to purchase and manage a property.  There are 2 groups: the General Partners (GP), a.k.a. active investors; and the Limited Partners (LP) a.k.a. passive investors.  The GP puts the deal together and does the work of managing the asset.  The LP is passive in that there is no work for these investors to do in the deal, but as an LP, you should understand the structure of the syndication to make an informed decision about your investment.

If you are new to syndications, you may not be familiar with the different ways a syndication can be structured.  You’ll want to understand the different ways it can be structured and if the structure fits your goals.

In syndications, there are normally a few fees and a splitting structure.

The most common fees:

  • Acquisition fee: This fee is assessed when the deal is closed.  It can also be called the due diligence fee.  It is common for the GP to assess a fee of 1-3% of the purchase price of the property to cover the work that goes into closing on a property.
  • Asset management fee: The asset management fee is usually a percent of the rent collected.  Typically, this is 1-2% of the collected rent and is used by the GP for the ongoing management of the asset.

These fees will be outlined in the Private Placement Memorandum (PPM), the contract between the GP and LP investors.

Outside of the fees, there are different ways the equity can be split.  Different deals have different structures.  It is important to understand the possible options so you can make an informed decision around what equity structure is right for you.

Different deals can take on different structures based on a myriad of factors.  Some of these include:

  • the type of asset
  • the investment strategy and business plan
  • the type of risk the investors are willing to take
  • market conditions

For me as an investor, it is important to have alignment of interest between the GP team and the LP investors.  Red flags could include high fees collected by the GP that are prioritized before investor returns.  It is important that both the GP team and the LP investors realize gains when the opportunity is successful.

The structure of the investment can take on different forms, but what is important is that there is an alignment of interests on all parties involved.  This makes for a more successful investment.  Below, I’ll talk about common structures found and what they mean.

 

Common Structures

 

Straight Equity Split

This is the simplest structure of all.  It is often represented as 70/30 or 60/40.  The first number is the percentage of what a passive investor gets and the second is the share for the general partner.  The idea here is that for every dollar gained as a return part goes to the passive investor and part to the general partner using a very simple rule.

 

Preferred Return Waterfall (aka Pref)

A preferred return is the first part of the return (the pref) goes to the passive investor.  The language the general partner would use is something like 8% pref then 70/30.  This means that the passive investor is paid first, before the general partner.  They are to hit the preferred return, in this example 8% return on investment in a given year.  After the pref is hit, then the equity split would kick in like a straight equity split.

 

Multiple Waterfalls

This is another example of the pref, but there could be multiple waterfalls.  For example, there could be 8% pref then 70/30 split (70% to the passive investor and 30% to the general partner).  But a second waterfall could exist , say after a 10% return is hit the general partner could be compensated more for finding a performing opportunity and the equity split after the second waterfall could be something like 50/50.

Another waterfall or barrier that could change the split is based on Internal Rate of Return (IRR).  IRR is an annualized effective compounded return rate.  The equation is somewhat complicated and deserving of its own blog post, but the idea is that it is a time-weighted return where today’s dollars are worth more than tomorrow’s dollars.  There could be a preferred IRR for the performance of the investment over the whole period, after which the equity split changes.

 

Different Share Types for Passive Investors

Another structure that is gaining popularity recently is having 2 different structures for different investors.  This is often set up as two different pref levels.  A general partner may offer part of the investment with a higher pref but with a lower equity split after it is met and another with a lower pref but higher equity split.  To make this easier to understand, I’ll give some concrete examples.  These numbers are made up but can help you visualize what this structure could look like.

There could be 2 share types:

  • A shares: 10% pref, 10/90 equity split.
  • B shares: 6% pref, 70/30 equity split.

In this structure, it is common to pay the A shares first.  These investors are investing for a specific return and would be “paid” first before the B shares.  They have less of an upside if the opportunity performs very well.  B shares would be “paid” after the A shares but have a larger upside (70% of the equity after the waterfalls are hit).  Investors like this would often see more of their gains at the end of the deal vs up front.  They are also more contingent on the overall performance of the opportunity.

 

Which split is right for you?

This is a very personal question and would need to fit your investment goals.  Ultimately, when an operator presents a potential deal, they will outline estimated payouts per year based on their current modelling.  Obviously, market conditions can change, but as a passive investor you’ll want to decide what matters most to you.  Do you want more consistent cash flow throughout the lifetime of the investment or do you want to realize a possible bigger upside at the end?  If you want a possible bigger upside at the end of the deal, maybe a bigger equity split and lower pref is for you.

The biggest thing to keep in mind is that the passive investor and the general partner have alignment of interests and that as the passive investor, you trust the general partner team.  If the general partner gets an enormous payout regardless of performance, that is a red flag.  If the general partner passes all gains to the passive investor and none to them, that is also a red flag.  You want the general partner to be invested in the deal’s success with you.