Preferred Returns and Waterfalls: Syndication Payment Structures
Prospective investors joining a real estate syndication get a deluge of paperwork, including a legal document called the private placement memorandum (PPM). However, the PPM is anything but boring as it includes the terms for the most exciting part of investing: profit distribution.
Understanding the Syndication Compensation Structure
The PPM details both the time and quantity of payouts for all parties in the syndication.
Limited partners contribute the lion’s share of the capital to fund the project, so they can expect the PPM to address the repayment of capital plus continued returns based on the proportion of their original investment.
The PPM usually includes an acquisition fee of 1 to 5 percent paid to the sponsor at closing. To earn this fee, the sponsor found the subject property, did an extreme amount of research to vet it, gathered investors, performed due diligence, and ultimately closed the purchase transaction.
General partners usually contribute at least a small portion of capital, so their payouts will reflect that. Moreso, general partners provide the skill and time crucial for the project’s success. As such, the payout structure reflects their compensation for the project’s performance. This usually takes the form of a profit split.
Waterfalls and Profit Splits
The rate and proportions of distributions vary throughout the life cycle of a syndication. Doing so rewards the money investors with a return of capital as soon as possible and motivates sponsors to run a successful project.
The PPM defines the profit split between the general and limited partners throughout the life of the syndication. A structure that includes changing profit divisions is called a waterfall. This is based on the metaphor of profits pooling on one level before spilling over to another.
For example, the profit split may be 60/40 in favor of the LPs until a specific benchmark or hurdle is met. Then, the split may change to 50/50, which rewards the sponsor for their work in the project’s profitability.
Ultimately, the goal of the waterfall arrangement is to minimize risk to money investors by giving them early profits but provide the sponsor with a disparate amount of earnings in reward of a highly profitable asset.
The hurdles for shifting to the next level of the waterfall vary by project. For example, some use an internal rate of return, which is the percentage that reflects the amount earned based on the amount invested.
Preferred Returns
A common way for syndications to lower the risk to the limited partners is by implementing preferred returns in the payout method. A preferred return also called a pref, prioritizes the very first profits to the LPs.
Nobody gets a portion of the profits in syndications with a preferred return until the investors entitled to the pref receive that amount. The pref is expressed as a percentage, and 8 percent is typical.
Takeaways for Investors
When evaluating a possible syndication for investment, ensure that the payment structure addresses your appetite for risk versus reward. For more information regarding my open projects, get in touch with me at Cameron’s CRE.
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