Disclaimer: The views and opinions mentioned in this blog post are provided for informational purposes only and should not be understood as formal counsel or an offer for any securities
Intro
Through this blog, my constant intent is to socialize information I have struggled to easily extract off the web and this post is another one in that series.
In the beginning, I wanted to use my money to make the investments but then came a time when I felt comfortable using other people's money because I had the framework built out and made the mistakes.
The main question then was how does one even split the returns?
Turned out it was not an easy question to answer, so I went on to do some deep work to analyze a variety of real estate firms including crowdfunding sites, syndications, PE funds, and created a matrix for pattern recognition. And below was the outcome!
This post is the synthesis of this research reflected in 3 standard models that are most common out there.
In reality, you can easily follow the 80/20 approach here use these for the first deal structure as a rookie but then you can get creative also depending on few other factors
What are these factors?
- Your relationship with the investor
- Your track record
- Your objectives/values
- How hot or cold the market is
- Investors return objectives
- Investors' risk tolerance
But I don’t want to boil the ocean - let’s manage our focus and go for the standard approach from the marketplace which could be used in your starting deals.
Let's assume you are the operator or the General Partner(GP) .i.e the partner who does the work and you work with investors who will provide the capital also called Limited Partner(LP)
So the main question to answer here is how do you structure the deal?
The first thought to surface here might be to do a 50/50 split or some other simple split.
One puts all the capital and stays passive and the other does the work and brings the knowledge/people/processes and the profits are split 50/50 including cash flow.
I have read of people doing this already but I personally found it to be a tough sell if you are the GP because in most cases the return does not work for LPs at least in my case, because my friends are intelligent investors.
So what are some attractive models in working with passive investors who only give you capital?
Note: GPs make money through some fees also but as a newbie GP I would recommend foregoing the fees.
Option #1: X% LP first return or Preferred return only model
Please note: This model is not so common but the simplest one. X is most commonly 8%.
Who is it for? Passive investors who are just looking to make income but also want ownership in real estate. When there is a hot market going up, they can potentially pull their capital out with a cash-out refi in a couple of years and still have long term ownership in the property making that preferred return.
How is cash flow divided? LPs receive x%(usually 8%) return annualized on the money they invested. Any remaining cash goes to the GPs. The most common distribution schedule is either monthly or quarterly. In case the annual return is below 8%, then all of it will go to the LPs.
What happens when you do cash-out refinance? If you refinance, any capital pulled out will go back to LPs till all their initial investment is paid out. Any remaining balance will go to LPs so they get an 8% total annualized return. The remaining capital goes to the GPs.
LPs continue making the 8% return annually even if all the capital has been returned already since the LPs still have ownership of the asset.
What happens when there is a sale?
- All the initial investment goes back to the LPs first if not returned already.
- If LPs haven't received their pref return, then they get all that before GPs get anything.
- Any remaining balance goes to the GPs
Essentially, passive investors know that a certain return is somewhat guaranteed, called a preferred return, no matter the performance of the asset. This gives passive investors some certainty that they will be first to get the profits before returns go to anyone else + if there is refi, they can pull their money out and still keep making money for a long time so infinite return potential.
This model favors GPs and is the least common amongst these three models.
Option #2: X% Preferred Return + Profit Split
Again, X is most commonly 7-8%. And profit split is:
- 80/20 - Recommend this if you do not have much of a track record.
- 70/30 - If you have a good track record
If I was a limited partner, this model is a clear winner over #1. I have the potential to make way more return beyond the preferred return.
Who is it for? Passive investors who are looking to make income but also want the profit beyond the preferred return when there is a capital event like cash-out refinancing or a sale of the property.
How is cash flow divided? LPs receive x%(usually 8%) return annualized on the money they invested. Any remaining cash flow goes to the GPs - unless you decide to apply the profit split to the remaining cash flow depending on the LP's appetite, in which case, residual cash flow will be divided 80/20.
The most common distribution schedule is either monthly or quarterly. In case the annual return is below 8%, then all of it will go to the LPs.
What happens when you do cash-out refinance? If you refinance, any capital pulled out will go back to LPs till all their initial investment is paid out.
The remaining will go to LPs till they have the preferred return threshold met.
Any remaining balance is divided in a pre-determined profit split as stated above- either 70/30 or 80/20 etc, let's say 80/20 for simplicity.
What happens at the sale of the asset
- All the initial investment goes back to the LPs first if not returned already earlier
- If LPs haven't received their pref return of 8 %, then they get all that before GPs get anything.
- Any remaining balance is divided with an 80/20 split.
- LPs get 80 of the remaining balance
- GP's get 20 percent of the remaining balance
Option #3: X% Preferred Return + Profit split with IRR Hurdle
Note: X is again commonly 7-8%. The profit split is 70/30 or 80/20. I have seen IRR hurdle to be anywhere between 12 and 16 %
This is perhaps the most common model of all.
Who is it for? Passive investors who are looking to make income but also want the upside when there is a capital event like refinancing or a sale of the property.
How is cash flow divided? LPs receive x%(usually 8%) return annualized on the money they invested. Any remaining cash flow goes to the GPs - unless you decide to apply the profit split to the remaining cash flow depending on the LP's appetite, in which case, residual cash flow will be divided 80/20.
The most common distribution schedule is either monthly or quarterly.
In case the annual return is below 8%, then all of it will go to the LPs.
What happens when you do cash-out refinance? If you refinance, any capital pulled out will go back to LPs till all their initial investment is paid out.
- The remaining will go to LPs till they have the preferred return threshold met.
- Any remaining balance is divided in a pre-determined profit split as stated above- either 70/30 or 80/20 etc, let's say 80/20 for simplicity.
- If the IRR hurdle is met, the remaining profit is divided 50/50.
What happens at the sale of the asset
- All the initial investment goes back to the LPs first.
- Total return to LPs is calculated up until this point including preferred return + any return from refinancing event.
- If LPs haven't their pref return of let's say 8 %, then they get all that before GPs get anything.
- Any remaining balance is divided up until the LPs receive a total of x% IRR - I have seen anywhere from 12 to 16 % as the hurdle rate.
- The remaining balance then is divided as 50/50
Please note: There can be more hurdles. For example, 70/30 up to 13% IRR, 60/40 up to a 15% IRR, and 50/50 thereafter.
These structures are limited only by the creativity of the sponsor and their lawyers and what capital investors are comfortable with.
There could be many ways to go about it and with experience, you can get more creative.
If sponsors can achieve an IRR of 20%, then sponsors typically start to get a bigger slice of ongoing returns.
Thoughts on fees
You might notice that GPs in the above models usually only make money when there is a capital event. That is not the case usually and experienced GPs are able to charge fees along the way for different reasons, mostly for operating the business and costs that come along with it. A typical fee charter looks like below
Note that this is up for debate. Some investors might not like extra fees especially if GPs are not experienced.
The bottom line
These deal structures in real estate deals are a very common way to protect the capital of limited partners who provide the majority of the funds as well as incentivize the general partner to produce as high a return as possible.
We don't have to re-invent the wheel and come up with our own structures especially when we are starting out.
Disclaimer: The views and opinions mentioned in this blog post are provided for informational purposes only and should not be understood as formal counsel or an offer for any securities.
