How do you structure your first ever deal in real estate that would inevitably lead to a win-win situation? Brian Burke lists down the three common ways you can use and integrate when structuring real estate deals. Brian is the President and CEO of Praxis Capital, Inc, a vertically-integrated real estate for private equity real estate firms that acquired over 700 properties including over 2,000 multifamily units with the assistance of a proprietary software that he wrote himself. A firm believer that a deal should be structured in different ways, Brian touches on preferred return, splits and fees, and everything that needs to be addressed in the process. Your goal is to be able to offer investors that would get their interest, and that’s why it’s crucial to unlearn what didn’t work before and embrace improvement. Find out the common problems that people make when structuring deals as Brian gets us at the edge of our seat.
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Structuring Real Estate Deals with Brian Burke
Our guest is Brian Burke. Thanks for being on the show again, Brian.
Thanks for having me.
I’m pleased to have Brian back on the show. He’s an expert in the real estate syndication field. If you want to go back and read the previous episode that he was on, it was show number WS23 where we talked a lot more about how he got into this business and his background. He’s the President and CEO of Praxis Capital, Inc. It is a vertically integrated private equity real estate firm that’s acquired over 700 properties including over 2,000 multifamily units with the assistance of proprietary software that he wrote himself. Is there anything else you’d like to tell the audience about your background to get us started? We’re going to jump into this question that everybody has. I’ve had it so many times about structuring deals and why we structure deals in a specific way. Is there anything specific you’d like to tell the audience about what you’re up to?
We’re up to buying more apartment buildings. The core of our business is multifamily. We’ll close on 539 units in 2019 and hopefully, we’ll find a way to squeak out another 600 before the year is over and see if we can get a comma behind us.
I get the question all the time about structuring deals and people want me to ask more about structuring deals. I knew you’re the expert. You’ve had so much experience in this space. Get us started on ways that we should be thinking about structuring deals and why we would structure them one way or over the other. Give us maybe some examples of how you’ve structured deals in the past.
The deal structures are a very complicated topic. There are a lot of different ways you can structure deals and it depends a lot on the circumstances. The most simple way to structure a deal is just a simple profit split and this goes back to the age-old thing where you go, “I’ll do all the work. You put up all the money and we’ll split the profits.” That’s something that’s been going on forever and that’s the simplest way you can structure a deal. The simplicity though ends right there. As you get into bigger deals, more complicated deals, longer deals, there are so many different things that come into play that will influence deal structure that there becomes almost an infinite number of ways to do it. Primarily, there are three different ways to structure a deal that are most common. The first would be your simple profit split. The second way would be a preferred return and then a split of whatever is left over after the preferred return. The next one would be a multi-tiered waterfall where you have a preferred return and then a split until you reach another return and so on for as many levels as you want or need. Those three main ways are the ways that you would do a structure.
A regular profit split is usually like a JV deal. You wouldn’t syndicate something on that level. Is that correct?
You likely wouldn’t although it is possible. I’ve done it. What we’ve done is a house flipping fund where we’re going to put together some money, we’re going to buy houses, fix them up and resell them. The profits from each deal are split between an investor or a group of investors and the sponsor who’s doing all the work. It fits well in a structure like that because you’re always turning over properties, you’re buying and selling. That stuff is happening rather quickly. You’re generating profits on a fairly consistent basis that are significant profits and you’re doing a lot of work. Flipping houses is a day job. It’s not a set it and forget it business so you’re always working and as a sponsor, you always need to be getting paid and as an investor, you want to get paid as houses sell. Profits put works well for those types of investments. It does not work well when you’re doing something where you’re like, “Let’s raise $5 million or $10 million. We’re going to buy a $10 million or $20 million apartment building. We’re going to spend some time in the early portion of the period to fix it up and increase rents. We’re going to drive revenue and wait a few years and then sell.” The straight profit split doesn’t work in that scenario.
[bctt tweet=”There’s more to a deal structure than just splits.” username=””]
The most common scenario in this industry is the preferred return and then a split after the pref. Is that correct?
The last two are equally common. It depends on the sponsor. You’ll see a lot of single tier waterfalls where you’ve got a pref in one split and then you’ll see a lot of multi-tiered waterfalls pref and then multiple hurdle splits. That’s how we do ours. We will have multiple hurdles although we’ve done deals in the past where we had just a single hurdle split. You can see it done both ways.
Go into the split a little bit in case somebody doesn’t know what we’re talking about. You have preferred returning and the investor is getting that amount before anybody else is paid. That split afterward, can you elaborate on that a little bit?
The split is a division of profits after the preferred return hurdle has been met. Let’s first define what a preferred return is and then we can get into how the split works because you have to understand the preferred return in order to understand the split. Some people think a preferred return is an interest on your money and some people think it’s a guaranteed check that you get every month of every quarter. It’s neither of those. A preferred return means that you’re first in line to receive cashflow. You’re an investor in a deal and let’s say you have an 8% preferred return. What would happen is if there’s any cash to distribute at all, you will get all of it until such time as you’ve received an 8% return on your capital.
There are a lot of different ways you can make a preferred return work. I’ve seen it done a lot of different ways. You can have it be cumulative. Let’s say we distribute 4% in the first year and we would have to distribute 12% in the second year to make it whole. If we didn’t, whatever the shortfall was carries over into the third year and so on. Any amount below the preferred return hurdle that doesn’t get distributed accumulates and carries over to the next tier. That’s a cumulative preferred return. You can also have a non-cumulative preferred return where you get 100% of the cashflow up to 80% but every year, it resets back to zero and whatever wasn’t distributed does not accumulate to the next tier. That’s uncommon, but it is out there.
How would an investor know that? Where would they find that and how would they know if it was not a cumulative return?
You can get the answer from the sponsor and you can also get the answer from the operating agreement. One of the documents in any real estate syndication is an operating agreement. That agreement governs the entire relationship between the investor and the sponsors. In the waterfall distribution section, part of that talks about how cashflow to be distributed is either going to say there or there’s going to be a term in the preferred return that has capitalized first letters. It means that that term is defined somewhere in the agreement. Let’s say that says, “Until their investors reach 8% annualized rate of return, they get a 100% of the profits and annualized rate of return is capitalized.” If you see that, that’s telling you to go look somewhere else in the operating agreement for the definition and for the term annualized rate of return.
In that definition, it should say whether it’s cumulative or non-cumulative. The other thing you want to look for is if it’s compounding or non-compounding. In other words, if 4% carries over until the following year, you earn a preferred return on the undistributed 4% as well as on your capital. There are a lot of different ways that preferred returns can work. There are nuances in it, but in the simplest terms, a preferred return means you get a 100% of the cashflow until you’ve received an 8% return on your money. Once you’ve reached that level, then whatever cash is left over drops to the next tier and that’s where that split comes into play.
What’s going to happen at the split and how do we decide where that split should be? Most of us here will do 70/30 split or 80/20. What’s going to be the most common and why?
The range for most common is somewhere between 70% and 80% of the investor. It depends. I’ve seen splits as low as 50/50 after a pref. I’ve seen splits as high as 90/10 after a pref. It depends on a lot of factors. People always think like, “90/10 is better. I want that. I’m going to invest in that deal because that’s a 90/10 split and the other guy is an 80/20 split.” I’ve seen that happen, but there’s more to deal structure than just splits. There are also fees. I’ve seen 90/10 splits but with a 1% asset management fee calculated off of property value, which on a $20 million building you can be talking $200,000 a year asset management fee. Giving a 90/10 split is a lot more appropriate than an 80/20 split when the other guy is offering an 80/20 split with a 1% asset management fee calculated or collected income. You have to look at all the nuances of fees and splits before making a decision that one structure is better than another because everything influences everything else.
You’re taking in the whole picture and not just seeing the split or how much you think you’re getting in return and taking in what the investors or what the deal sponsors are gleaming, and fees and charging. What are some other nuances or things that we need to understand about a split? As a sponsor, the 50/50 versus a 70/30, when are you going to do a 50/50?
We’ve done 50/50s on a home building fund where we’re building houses and it’s very labor intensive. The general contractor is part of the GP group and this isn’t taking a general contracting fee or profit and overhead out of the deal. It’s only being compensated from the split of the profits so a 50/50 split works well there. It works well at a house flipping fund. At the bottom of the real estate market, we did a buy and hold fund where we are buying single-family homes to hold as rentals after the foreclosures in California. We created a large fund and that was a straight 70/30 split, 70% to the investor and 30% to us with no preferred return.
At the multifamily side, we’re going to start at 70/30 after an eight pref. Some deals though we’ve done a bit of 80/20 over an eight pref. It depends on what are the returns of the deal and what’s the cashflow of the deal. It’s funny because people will call and ask like, “I want to learn more about your offerings. What are your splits and fees?” It’s as if that’s the first question you should be asking. It’s the last question you should be asking because you want to know a lot more about the sponsor and then what they’re charging. Nevertheless, there’s no menu that you can say, “Here are our splits and fees on every deal.” It doesn’t work that way.
Some deals produce more cashflow, some produce less, some have more backend appreciation, and some it’s less. What we’re doing is we’re crafting the splits and fees back into the returns that we need to generate to make our investors interested. If you’re the sponsor, what you should charge in splits and fees depends on supply and demand and the cashflow of the deal. Let’s break those two into two separate pieces and let’s start with the cashflow of the deal. You have to model the deal out and determine what’s available even to be split before you can decide how much you can take because now you’re backing into a return. The second piece is the supply and demand. What I mean by that is how many investors do you have wanting to fund your deal and how much money do you need?
If you’ve got a lot more investors than you need for money, then you can command a premium. If you’re trying to attract investors and you need to raise $10 million and you only know five people. Those five people only have $100,000 each that means you’ve got to go meet a lot of people and get them interested in your deal. You’re going to have to offer a richer deal to those investors to attract them. The other piece of the puzzle is it depends a lot on the sponsor’s track record, capacity, LinkedIn business, experience, and all those other things. If this is your first deal, you’re going to have to offer investors a different menu of splits and fees than of someone who’s on their 700th deal.
I liked how you talked about setting it up and you’re going to back your way into that as far as figuring out what you can offer investors. Your goal is to be able to offer investors so they’re interested. If you’re more experienced, you’re already going to have that track record with your investors as well as opposed to being somebody brand new. You’re meeting these investors for the first time, they’ve never invested with you before.
[bctt tweet=”People say yes when they trust you.” username=””]
You don’t know what they’re expecting. You don’t know what rate of return is going to get them to say they’ll do that deal. There should be no rate of return that gets somebody to say yes and there isn’t. People say yes because they trust you. If it’s your very first deal, before they even think about, “What rate of return do I need to get to attract investors?” You should instead be thinking, “How do I bring people up that trust curve? How do I get someone that’s never met me before to trust me with $100,000, $250,000 or $1 million or their hard-earned money that they value a lot? How do I get them to trust me that I’m not going to screw that up and lose it?” If it’s your first deal, that’s a very difficult trust curve to climb. It’s one of the reasons why I always say, “Don’t think you have to go straight to the big leagues. It’s okay to do a $100,000 house flip deal with an investor to get them to trust that you’re not going to screw it up. Build your way up to doing $10 million deals.” I’ve been doing this for many years and I didn’t cross the two comma mark for at least a decade of being in this business. It takes a long time to build that trust up and a split isn’t going to do it.
What about the waterfall? Let’s move into the waterfall structure a little bit and what that is.
The term waterfall applies to any of these different deal structures. What you’re looking at is the cash generated by the project. That goes into the top of a waterfall and then from that point forward, what happens to it is all your deal structure. We’ve talked about splitting it with someone. We’ve talked about having a preferred return and then everything above that preferred return gets split. The next level of complexity is where you have multiple split tiers. This might work like this. I’ll say it quickly and then we’ll break it down. Let’s say you do an eight pref followed by a 70/30 to a twelve, followed by a 60/40 to a fifteen, and followed by a 50/50 thereafter. The first step is you have your 8% preferred return. We already talked about how that works. Investors get 100% of the cashflow until they reach 8%. The next step is 70/30 to a 12.
The way this works is after you’ve paid out the 8%, the cash that’s left is $100,000 and $50,000 of it went to pay an 8% preferred return. There’s another $50,000 left. That’s what we’re talking about here. That money after the preferred return has been paid, that drops to the next tier. In the next tier, we’re going to 70/30 to a twelve, so what you first have to be able to do is to track how much does it take to bring the investor to a 12% return. You back into that and let’s say they get 70% of the cashflow that was leftover until they hit that number and the sponsor gets 30%. Once the investor has reached that 12% return and the investor got their 30% piece, let’s say we’ve got $30,000 left. That next $30,000 drops to the next tier and the investor gets 60% of that until they reach a 15% rate of return. Whatever is left after that has taken place drop to the final tier and that’s a 50/50 tier so you split that half and half. That’s how it works.
Why would we do that as opposed to 70/30 with eight pref?
The theory behind it is we think that this deal is going to be a grand slam. That’s our opinion. We think we’re going to do well on this deal, but to do so it’s going to require a lot of work from us as a sponsor. We think we can get it to the finish line. We want to be rewarded for all that extra effort and for all that hard work of bringing this thing all the way home. However, if the deal doesn’t do as good as we think, then we should be rewarded less. You get more of the profits as an investor if we don’t perform as well. The theory is if the deal only throws off an 8% return, the investor gets all of it and we as the sponsor getting nothing.
If it throws off a twelve, then the investor got an 8% pref and then we split 70/30. That’s the incremental piece of cash that happened between the eight and the twelve at 4%. We split that at 70/30. If the deal does a 25, a 70/30 split, you would deliver the sponsor or the investor would get a 20% return. We get this little amount for all that we did and all that success we created. We could get rewarded more heavily for that for what we produced. The multi-tier waterfall allows us to participate in a greater way as the performance increases and in a lesser way as the performance decreases. It’s a bit incentive and it’s a bit reward.
What type of class or property or maybe a development versus a class C property? When would you see that per class?
We’d do it on most of our class A, B and C. We’ve done it on A deals, B deals and C deals. In development deals, not so much. Usually, we’ll stick to a straight split on a development deal, but there’s certainly no reason why you couldn’t do that on a development deal as well. It applies to anything where you feel that you have the potential to bring it home.
It wouldn’t matter the class. If we had this class C and where we’re going to bring it up. You’re going to decide that like you back into the deal when you’re underwriting it.
I know that if we can deliver our investors a 14% internal rate of return, our investors will absorb that all day long. When we’re looking at the cashflow coming out of the property and the exit proceeds and everything, if it’s a 20% return net to the investor, then we know we could participate in a greater way and we could participate more of the profits as that return is increased. We don’t need to offer anything that high. If we did, people would be afraid of the deal because they’re like, “There’s a 20% return. It must be high risk.” We always are trying to solve for that mid-teens return range. This is the supply and demand for capital. We’ve been doing this for a long time. We have a very broad investor base. If you don’t have that and if you need to produce 17% or 18% return to get your investors interested, then this multi-tiered waterfall might not be a fit for that particular case.
What kind of investor feedback do you get for waterfall versus regular split or other types of structure?
When you show them the multi-tiered waterfall, it’s a little bit of the deer in headlights look. We spend a lot of time explaining exactly how it works, walking people through it, and showing them this is how A leads to B which leads to C. It’s all about investor education just like anything else. Why would you use a floating rate loan over a fixed rate loan when you’re going to do a three-year hold? Why not get a ten-year fixed rate debt? It’s because there’s yield maintenance and you’ll have to pay $2 million to get out a loan. That’s all part of investor education. You need to educate people why this makes sense. Once you do that, we haven’t had any issue with it at all.
Is a waterfall something you were doing early in your syndication career?
Early in my syndication career, I was doing a straight profits split. The next ones I was doing was a preferred return with a single hurdle. It wasn’t until later on that we’d done a few hundred deals and a lot of single-family stuff. On the multifamily side, we had done a few deals before we started in a multi-tiered waterfall. We didn’t go straight to it.
Are there any common problems that people make where you see them structuring deals and you think, “Why didn’t they do it this way? They should have thought about this.”
[bctt tweet=”Flipping houses is a day job. It’s not a set-it-and-forget-it business.” username=””]
We see that all the time. It’s like, “What were they thinking? Why are they doing that?” There’s so many, but mostly it relates to the underwriting side. It’s usually the cash going into the waterfall that’s the bigger problem and not as much the cash coming out. The structure just depends on the appetite of your investors and what net return you’re going to deliver to them. That the trouble with a waterfall is it’s like a computer. It’s garbage in, garbage out. If the cashflow is going into the waterfall fundamentally flawed because of bad underwriting, then no amount of deal structure is going to save you from that. You can’t structure your way out of it. Assuming that the cashflow going into the waterfall is solid, you can do anything you want with the waterfall because this is the part where it’s not about underwriting a deal.
This is all about negotiation or a mutual agreement between you and your investors. If your investors are rejecting your proposed waterfall splits because they think it’s too rich to you, the negotiation isn’t going well for you as a sponsor. You need to enrich it or the investors aren’t going to invest. It’s all about coming to common ground with your investors and making sure everybody is getting what they want out of the deal. Nobody is getting overly fat and no one is taking advantage of either side, but it’s fair to everyone. That’s the beauty of these multi-tiered waterfalls. It’s fair for everyone. If the deal does well because you do a good job as a sponsor, you’ll get heavily rewarded. If you do a bad job as a sponsor, the investors have the protection of at least going to get 100% of the cashflows until they reach an 8% return.
Brian, I appreciate you elaborating on the deal structure. Many people are going to going to love this show. I didn’t ask you when you were on the show before on how you like to give back.
There are a couple of ways. I like to give back by just answering people’s questions on BiggerPockets.com. For me, it’s the number one way to share knowledge and give back and help people that are stuck in a situation. The other way I like to give back is myself and four other guys from BP got together and formed a charity called A Hero’s Home and you can find it at AHerosHome.org. Our mission is we plan to give away all fixed up and free and clear a house to a deserving US veteran or first responder. We’ve been raising money in that charity now for a few months. We’re a little over halfway to our goal. Memphis Invest which is a big turnkey outfit here in the United States is one of our partners. They’re going to help us find a house. It’s a day I look forward to. That’s my other way of giving back.
Tell the audience how they can learn more about you and your company.
There are two ways. One would be through BiggerPockets.com. You can follow what I say there on that forum. I’ve been on the BiggerPockets Podcast three times, also through our company’s website which is PraxCap.com. There’s information on there about what we do and how we do it.
Brian, thank you so much for being on the show. I appreciate you sharing your knowledge, experience and expertise with our audience. I know they’ve learned a lot and I have as well. We look forward to having you back on the show. I appreciate the audience being with us. I hope you will go to Life Bridge Capital and connect with me. Go to The Real Estate Syndication Show on Facebook and join the group. Ask questions on there and I’ll try to get your questions answered. Have a great day. We will talk to each of you next time.
- WS23 – Past episode
- Praxis Capital, Inc
- Memphis Invest
- BiggerPockets.com – Brian Burke
- BiggerPockets Podcast – episode with Brian Burke
- The Real Estate Syndication Show – Facebook Group
About Brian Burke
Brian Burke is President / CEO of Praxis Capital Inc, a vertically integrated real estate private equity investment firm. Praxis operates on multiple platforms, currently managing active syndications for the acquisition of multifamily, single family, and opportunistic residential assets in US growth markets.
Brian has acquired over $400 million in real estate over a 30-year real estate investment career including over 2,500 multifamily units and more than 700 single-family homes, with the assistance of proprietary software that he wrote himself. Brian has subdivided land, built homes and constructed self-storage, but really prefers to reposition existing properties.
As a recognized expert Brian has been a frequent speaker at real estate forums and conferences; including the SF Bay Summit, Opal Family Office & Private Wealth Management Forum, the Keiretsu Real Estate Forum and the Institute for Private Investors. He has also served as co-host and real estate expert on the Fox News Radio show, “The Best of Investing”.
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