Real Estate Syndications Explained- Profit Splits
And I’m Dan with the High Yield Real Estate Investing Podcast
This is part three of a multipart series designed to educate you on what to expect as a passive investor in a real estate syndication. In our last two episodes we’ve covered who’s qualified to invest in a syndication, how the returns are calculated, and what fees the syndicator may charge. In this episode we’ll talk about how profits are split between the syndicator and investors and how your initial capital is returned to you.
When we discuss profits splits, we are defining how cash flow and the profits from the refinance or sale of the property are returned. Before a capital event like a refinance or sale occurs, we only have profits from cashflow to split. Let’s discuss a few common ways syndicators can split profits between themselves and their investors. There are as many ways to structure returns as there are companies offering these investments. But it’s important that you, the investor, understand how they work before you give someone your money.
The most common is a straight percentage split. A seventy-five twenty-five split means that the investors share 75 percent of the profits and the syndicators get the remaining 25. Usually you’ll see the vocabulary used as G-P L-P split. The GPs are the General Partners who manage the deal and the LPs are limited partners who invest their money. When you invest your money in a syndication with this structure, you’re buying a percentage of that 75%. I used 75 25 as an example. The split can be whatever the syndicator decides is fair to them and also attractive to the investors. a great stabilized property that doesn’t need any repairs and would be profitable to hold long term might be an 85 15 split. Maybe a heavy value add property that needed a lot of oversight would be a 70 30 split. While I don’t have any experience investing in new construction, I would posit that investing in a syndication that intended to build a 300 unit apartment complex and sell it upon completion would be a 50 50 split. A construction project takes far more oversight and effort by the syndicator than the long-term stabilized deal.
There’s also the preferred return that can be given in addition to the GP LP split. This is a guaranteed yearly return you’ll make for the life of the investment. In multifamily syndications, an 8% preferred return is a common benchmark. Essentially, the syndicator is guaranteeing that you’ll make 8% on your money each year. That money has to be paid to you first before the syndicator can take any profit for themselves. If investors have 1 million dollars invested in the deal then the first $80,000 in cash flow each year goes to the investors. If there was 150,000 dollars in cashflow for the year then the first 80,000 goes to investors and the remaining 70,000 is split between the GPs and LPs just like our previous example. But what if the property only returns 6% for the year? Well, the investors get that 6% and the remaining 2% gets added onto the preferred return for the next year. The GPs get nothing.
Some syndicators offer two or more tiers of investment in a single deal. Investors putting in larger sums of money might be offered a higher return than investors putting in the minimum. This higher return could be in the form of a higher preferred return, or higher equity split with the GP. Or, investors could be given a choice of a higher preferred return but limited in the amount of equity given when the property sells versus a lower preferred return of cashflow and a higher equity split upon sale. Or, there could a tier of investors that only gets a preferred return. If you invest over a certain amount, you get the preferred return and an equity split.
There can also be something called an IRR hurdle. Let’s say that below a 13% IRR investors get an 8 percent preferred return and a 70/30 split. Once the investment clears 13% IRR for the year the GPs and LPs share a 50/50 split of the profits. A structure like this would ensure the GPs are motivated to make sure their investment clears that 13% hurdle.
Are you confused? It’s OK. Go back and listen to this again or come back to it in a few days.
Let’s talk about how you get you initial investment back. Some people with backgrounds in business assume that the cashflow you get from rents slowly recoups your initial investment. When the cumulative cashflow you receive equals your investment, any subsequent cashflow is your profit. But that’s not how it works in real estate. Generally, you expect to realize a profit from cashflow first. Then, at the end of the investment you get your initial capital back plus any returns from the sale of property. Here’s another reason why investing your money in a syndication is low risk. When the property sells, most syndicators will make sure the investors get ALL their money back before any profit split takes place. While loss of principal may be relatively common in the stock market and investing in businesses, it’s more uncommon in real estate and can drive a syndicator out of business if it happens even once.
So how would your returns be calculated if you invested in a syndication that has a 75 25 LP GP split? Take the gross income, subtract all the operating expenses as well as the replacement reserves and you get your returnable profit. This calculation is done for every period the syndicator said they would send out distributions. As an example, if a property made 100,000 in profit for the year then the investors would get 75,000 of that 100,000. Lets say you invested 100,000 into a 1 million dollar capital raise. Your slice of that 75,000 would be 7,500 since you contributed 10% to the capital raise.
It’s also important to note, again, that the returns the syndicator advertises usually include all expenses and their own profit taken out. If a syndicator advertises a 15% return then that’s what you should get. Also, if you think that a 25 percent cut of profit is high, then I would tell you to concentrate on what the return on and of your capital are. Those are the most important parts of the equation.
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