by Joe Firmin 3 ½ Minute Read
Don’t worry – it’s only 5 questions… easy peasy.
- What are the two most common types of syndication structures?
- What is the name of a structure that has a preferred return at a specific %, then as additional return % points are reached, new distribution splits are defined?
- What is the name of the structure that splits returns and cash flow distributions according to some pre-determined split (e.g., 50/50, 70/30)?
- OK, that’s it, I lied. Only 3 questions.
Did you get the answers?
Here they are and we’ll talk about them in detail just in case you didn’t ace the test:
- The Straight Split and The Waterfall
- The Waterfall
- The Straight Split
- We’ll talk also talk about how to choose between these two
Difficult? Nah. Come on, let’s dive in.
The Straight Split and The Waterfall
That’s it? Only 2 structures? No. But that’s what we’ll cover or this would be a book in itself. Like snowflakes, no two deals are the same. There could be many forms and types of splits, %’s, etc., but in the end they come down to these two basic forms. Which is better? Well – it depends! (of course!)
It depends on what YOU you want to do in your life? Are you in pursuit of passive income to match your salary? Are you investing to build a retirement account? What are your goals?
These questions, in addition to how much money and time you plan to invest in real estate matters exponentially in terms of deciding which types of real estate deals are best for you.
Similar to investing in a stock, as a passive investor in a real estate syndication, for example, you give up some overall control of the investment and the day-to-day decisions of the company You pool your money together with a group of investors to purchase a large piece of otherwise unaffordable property, like an 80-unit apartment complex. While you enjoy relief from the typical responsibilities and time-commitment landlording requires, you rely on the deal structure of the real estate syndication to dictate how the returns are distributed.
This post will walk you through the key component of syndications - the deal structure - which is how the returns will be split between you (and the other passive investors) and the general partners (the syndication or sponsor team).
So let’s jump in to each of the two structures: The Straight Split & The Waterfall
The Straight Split - Real Estate Syndication Structure #1
As the name suggests, this type of deal splits all returns (cash flow and profits from the sale) with the same percentage.
If a deal uses an 70/30 split, for example, 70% of all returns (monthly cash flow distributions and profits upon the sale of the property) get distributed to the limited partner investors (the group of passive investors). The other 30% is paid out to the general partners (the deal sponsors who are part of the syndication team).
No matter the amount of the returns on the property, 70% is distributed to passive investors and 30% is distributed to the syndicators. Pretty Straight.
The Waterfall - Real Estate Syndication Structure #2
Another commonly referred to payout structure for real estate syndications utilizes a preferred return (“pref”) waterfall.
In this type of deal, the passive investors get all of the first 8% of the returns, for example, and the general partners only receive distributions if the returns are above 8%. In the waterfall model, each few additional percentage points in returns activates a new split.
As an example, if you invest $100,000 into a syndication with an 8% preferred return, it may dictate that returns between 8%-14% are a 70/30 split (70% to limited partners and 30% to general partners) and returns beyond 14% are a 50/50 split.
If you think about it, the general partners aren’t likely to present a deal with a waterfall structure where they expect to make low returns because, with profits of just 8% or 10%, that wouldn’t be beneficial to them. For this reason, waterfall structure syndication deals can be a win-win - the general partners are incentivized and you’re getting preferential treatment for the first 8% of returns.
How to Choose the Best Real Estate Syndication Structure
Neither type of deal - straight split or waterfall - is actually better than the other. The choice completely depends on the deal itself coupled with your investment goals.
Many investors love the preferred return option because it feels a little like a guarantee (even though every deal is an investment – not a guaranteed return). However, preferred (waterfall) deals can offer more conservative returns, depending on the overall performance of the asset.
When The Waterfall Structure is Better
Let’s pretend a property returns about 10% each year consistently for 5 years and you’ve invested $100,000. With a waterfall structure (preferred return or “pref”) the majority of the distributions would go to the passive, limited partner investors (you).
For simplicity, a 70/30 straight split structure on your $100,000 investment returning 10% per year would yield you $7,000.
However, a waterfall structured deal with that same 10% would yield you 100% of $7,000 + 70% of $3,000, which totaled equals $9,100.
Key Point for Goal Consideration: When a property has high cash flow percentages for distribution, a waterfall structure provides higher distribution amounts to limited partners and a straight split provides more value to the general partners.
When the Straight Split is Better
Let’s pretend the same property in which you’ve invested $100,000 makes a high profit of 50% at the sale. A straight split on the sale will yield you 70% of $50,000, equaling $35,000.
If it were a waterfall structured deal, you would get 100% of $7,000 + 70% of $3,010 (the next 7% of returns) + 50% of $40,893, which totaled equals $29,553.50.
Same Key Point for Goal Consideration: When the sale of an asset yields high returns, a straight split distributes more money to limited partners and a waterfall structure distributes more money to the general partners.
Use Your Goals to Determine Which is Better for You
If your investing goals are centered toward ongoing passive income to replace your day job, a deal with a preferred return (waterfall structure) might better suit your needs because greater cash flow distributions throughout the project lifecycle are likely.
Just know that you may see lower returns at the sale of the asset. Cash investors (not using retirement money) are likely more drawn to this option since those ongoing cash flow distributions are quite attractive.
Otherwise, if your investing goals are more long term and you are interested in the appreciation and profits at the sale, you may focus on syndication deals with a straight split as those are likely to provide a larger percentage of profits to you at the exit.
Investors utilizing a self-directed IRA might fall into this category since cash flow distributions are untouchable until retirement anyway.
No choice is wrong, just different strokes for different folks. There’s money to be made in real estate syndications with either type of structure.
Just remember, you should always start with your goals in mind.
If you decide you want to be a hands-off investor and invest in real estate syndications, join the Freedom Network. It’s absolutely free to join with no commitment necessary, seriously. If you don’t join, we won’t be able to send you opportunities (sorry, SEC rules). So join today! Not sure how it will work? Check out this post to understand the logistics.