When looking for real estate syndication investment opportunities, keep in mind that not all projects are created equal. Syndications most frequently come in one of two structures that heighten or decrease risk in return for possible reward: waterfall and straight-split. Read on to learn about these common types of real estate syndication structures, how they work, and how they can impact your investment.
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Why Does Syndication Structure Matter?
The syndication structure is one of the terms of the deal that determines what order investors are paid. In a syndication, there are generally two classes of investors: general partners and limited partners. The general partner is the person, partnership, or other entity who is leading the transaction and may also be called the sponsor. The individual passive investors are the limited partners.
The structure of the deal determines how returns are divided up between the general and limited partners. When vetting any potential opportunity, it is wise to ensure you understand how the structure may impact your potential return.
Waterfall Structure
The waterfall structure is the most common type of real estate syndication structure. It gets its name from the fact that returns are distributed as a cascade through different groups of investors rather than equally. The limited partners and general partners will be separate classes, and there may even be multiple classes of limited partners.
Under a waterfall structure, 100 percent of the first returns will go to a specific class, or classes, of limited partners. Then, the returns will be split in whatever ratio the syndication documents define for further returns. Eight percent is a common percentage for the initial returns directed solely to the limited partners. That initial percentage is called ‘preferred returns’ or ‘pref.’
After the preferred returns are paid to the investors, subsequent returns will be split between the investors and sponsor. The split may change over the course of time or the amount earned, with the sponsors getting a large stake as more money is made.
Waterfall structures are often considered the gold standard for syndication deals. They are appealing to passive investors, because they have the best shot of getting some return on their investment with this method, even if the property does not perform as expected. Investors also like this structure, because they perceive it as a motivating force for the general partners: because the general partners are the last to see an income, they are incentivized to work hard in order to ensure the project succeeds beyond the preferred returns.
Straight-Split Structure
A straight-split real estate syndication structure is much easier to understand, requiring much less math. Under a straight-split structure, investors and sponsors receive returns based on a split from the first dollar to the last. For anyone in commissioned-based work, it is exactly the same as the split between the worker and the entity sponsoring the worker.
Common splits are 80/20 and 75/25, with the individual investors getting the greater amount. A straight-split structure will be a favorable option for investors in properties that end up making a lot of money, especially if the property nets high proceeds at the termination of the syndicate with the sale of the property.
Sponsor Investment & Returns
Although not a payout split for investors, it is important to consider the sponsor’s source of potential gains and their own personal investment. Some syndications are set up for the sponsor to receive hefty monthly or annual fees that are not based on the performance of the syndication, and that may create less incentive to maximize the property’s potential earnings and value. Similarly, if the sponsor invests little of their own money, they will not have the same financial risk if the project fails and may have less of an incentive to ensure the project is successful.
Consideration for Choosing a Syndication Based on Structure
Finding a syndication to invest in can be a challenge, especially for unaccredited investors. Given that syndicate investment opportunities are often filled on a first-come, first-served basis, the desire to pull the trigger quickly is certainly well-founded. However, the challenge of the search is not a sufficient reason to jump on the first opportunity that becomes available to you.
As with any investment, be sure that the opportunity aligns with your financial goals before committing. Syndications tie up your money for several years, or until the syndication terminates with the sale of the property. That’s a long time to be in a deal that does not suit your needs.
- Waterfall syndications have a better chance of providing passive income, if that is your goal. It is also the more conservative of the two structures. And, just like investing in index funds, the conservative choice is less likely to yield huge returns.
- Straight split syndications may be more appealing to you if an income stream is less your goal than realizing a good amount of appreciation on your investment. Straight split investors often see the most profit at the termination of the syndication, when the property is sold.
As always, the best investment is the one that is right for you and your financial goals. No matter how appealing the deal may seem, if it does not fit into your financial plan, it is not the right deal for you.
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