In preparation to become a real estate investor, the most essential step to take is establishing your investment goals.
What do you want investing to do for your life? Are you in pursuit of passive income to match your salary? Are you investing to build a retirement account?
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.
As an investor in a real estate syndication, for example, you give up some overall control of the investment and pool your money together with a group of investors in a large piece of otherwise unaffordable property, like a 300-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.
So, when exploring syndication deals in real estate, what do you look for? Where do you start? How do you know which deal structure is best?
This article 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 team).
Why Real Estate Syndications Are Structured Differently
Much like snowflakes, no two real estate syndication deals are the same. Some deals offer higher returns coupled with higher risk, and others are more conservative across the board.
Syndications are structured differently based on the market, the asset type, the preferences of the general partners, the location and condition of the asset, and so much more.
Before you invest, no matter the sponsor, market situation, or asset, you must ensure the syndication deal structure aligns with the investment goals you’ve set for yourself.
There are two common real estate syndication structures: The Straight Split & The Waterfall
Real Estate Syndication Structure #1 – The Straight Split
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 80/20 split, for example, 80% 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 20% 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, 80% is distributed to passive investors and 20% is distributed to the syndicators.
Real Estate Syndication Structure #2 – Waterfall
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 (80% to limited partners and 20% 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 are a win-win – the general partners are incentivized and you’re getting preferential treatment for the first 8% (the closest thing to a guarantee in investing).
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. 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).
An 80/20 straight split structure on your $100,000 investment returning 10% per year would yield you $8,000.
However, a waterfall structured deal with that same 10% would yield you 100% of $8,000 + 80% of $2,000, which equals $9,600.
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 80% of $50,000, equalling $40,000.
If it were a waterfall structured deal, you would get 100% of $8,000 + 80% of $6,000 + 50% of $36,000, which equals $30,800.
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.
Using Your Investing Goals to Determine Which Real Estate Syndication Structure is Best for You
If your personal investing goals are centered toward ongoing passive income, a deal with a preferred return (waterfall structure) might better suit your needs because greater cash flow distributions throughout the project lifecycle are likely.
The caveat here is, 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, and different people in a different investing situation with different goals are going to choose different deals. There’s money to be made in real estate syndications with either type of structure.
As usual, there are many factors to consider and you should always start with your goals in mind.