The Ultimate SPC Guide to Syndications: Going from “Active-Passive” Investor to an LP in Syndications and Private Placements

Share on facebook
Share on twitter
Share on linkedin
Share on email

Video version of this article with extra commentary:

In 2016, I paid over $30,000 to get the mentorship to be an apartment operator/investor. What I learned in the process was that I did not need to be a General Partner because I had enough income and net worth to invest as a Passive investor (LP). After doing turnkey single-family homes from 2009 for 7 years I was ready to graduate to bigger deals as a passive investor.

Technically, I paid $40,000 on this fiasco too.

Webinar – What are Syndications/Private Placements? – https://youtu.be/n_qsZHBOCS4

 

Again for me, it was simple math. The assumption was that my money would grow at 15-20% a year in part cashflow and equity & forced appreciation.

Note: market appreciation is sometimes considered as luck as it is not creating more value in the property with rehab or management improvement to increase the value or force the appreciation of the property.

I was on the flight path to Financial Independence. And this is why I have shifted my focus to non-investing activities and enjoying the journey.

[Private Equity kicks S&P500 butt]

Source: Cambridge Associates, “US Private Equity Index and Selected Benchmark Statistics,” March 31, 2017, https://40926u2govf9kuqen1ndit018su-wpengine.netdna-ssl.com/wp-content/uploads/2017/08/WEB-2017-Q1-USPE-Benchmark-Book-1.pdf. 19.03.4

I made the jump to MFH/Syndications after more than 7 years in the SFH mindset. Read more here.

Every investor is at different stages of the game. This article aims to offer guidance on when to make the jump to more scaleable syndications.

Like ‘Rome’ I believe all most paths lead to investing in Syndications (as long as you are not a jerk and can halfway network with people).

Should I invest in syndications or private placements without investment experience?

Most investors start by investing in single-family home rentals. The natural progression is to move into larger more scalable assets such as being an operator/general partner (GP) or passive investor/limited partner (LP) in a syndication. Most novice investors do their research and come to the conclusion after evaluating the scalability, economies of scale, and diversification that bigger deals are the better route, but is that what you should really do?

And by the way to be a General Partner you need to find the deal, run it, bring a large portion (25% of the total capital), and answer annoying questions from the bank like this:

 

Wait, what is a syndication or private placement?

I use an airplane analogy when I explain these syndications. In an airplane, the General Partners in the cockpit fly the airplane (find deal, negotiate, find investors, line up lending, manage the 3rd party property management, operate the investment). They are typically signing on the debt and their net worth needs to be greater than the loan size. In coach, you have the passive investors or Limited Partners who come on the plane and go to sleep and hopefully get their returns. I look for both because its all about putting more people together and leveraging each other’s strengths.

A typical structure of a Single Asset LLC syndication

(Limited partners will be “Investor 1,2,3…”)

Asset – The subject investment property at 123 main street.

XYZ LLC – The LLC that has the title to the Asset

Class B Member – This is the managing members or GP (the cockpit in the airplane analogy)

Promote Entity – This can be made up multiple GPs

Class A Members – This is the LP members

Sponsor LLC – The general partners typically put some skin in the game usually 10% of the total raise

Investor 1,2,3 – These are the LPs

Other diagrams as not all things are the same but similar

What goes on in that cockpit?

When I started to invest I started as a LP. Frankly, I did not add any other value other than the capital I brought in. When people started to follow me into the deal and I was able to bring in more than $1M in one deal I got invited into the GP. Its was a cool place to learn what really goes on in the deal. Not everything is communicated to the LP for sure but for most times a good reason. As a new investor, it was a great place to learn from being behind the curtain.

Here is what the GP does and why they deserve the extra compensation:

  1. Source and identify assets

  2. Underwrite and discover hidden value

  3. Pursue, negotiate and win deals

  4. Develop asset business plans

  5. Negotiate purchase and sale agreements

  6. Conduct thorough due diligence

  7. Secure financing

  8. Close deals

  9. Manage assets

  10. Lease to new tenants

  11. Renew leases with existing tenants

  12. Perform and manage capital expenditure projects

  13. Execute asset business plans

  14. Dispose of assets; and

  15. Deliver investment returns

Bigger is better

Theoretically, it does make sense. Larger investment deals, such as syndications or apartments, would likely bring in larger cash flow and better deals due to better teams. If you do the math, you will likely net at least $100-300/month per property with a single-family turnkey rental. Assuming you earn a decent wage as W2 employee, you will probably need 20-40 of these single-family rentals to replace your income.

Cost segregations that typically cost around $5,000 create bonus depreciation. Bonus depreciation creates more upfront depreciation – often front loading in the first year of ownership. This is only practical in larger assets or scale.

Not making any promises as depreciation amount is primarily based off building specifics and amount of leverage used in a deal but here is a real-life example from a $50K investment in the first year K-1 in 2018 utilizing cost segregation.

Passive Losses!

Note this is a Class C apartment deal

Cost Segregation & Bonus Depreciation – https://simplepassivecashflow.com/costseg/

From Tax-Free Wealth by Tom Wheelwright – more on taxes

I personally had 11 single-family homes, but experienced one or two evictions per year. On top of that, there could (and have) been other big maintenance and capital expenditure events that happen (3-4 a year with the same sample size of 11 homes). In other words, single-family homes can only get you so far and you will need to invest in more to truly generate more cash flow.

Thus, investing in syndications can be an attractive way to achieve true financial freedom because it is even more passive than SFH’s.

And there isn’t the PITA associated with doing Turnkey rentals.

 

The caveat

But before you jump the gun, let us assess the full picture. From 2016-2018, I have had over 1000 strategy calls with real estate investors and coaching clients. (Today Calls are only available to Hui Deal Pipeline Club members) Many new real estate investors want to skip investing in single-family homes and jump into the deep side of the pool and invest in large syndications as a private placement. Who knows if they can swim? Some individuals can make this jump into syndications. Great for them! Keep in mind that this transition is a big step that requires more capital, a larger barrier-to-entry, skills, network, and unequivocally more risk. It might make sense to get a mentor to point you in the right direction.

If you are planning on being an operator or a general partner (GP) with no prior experience then I think you are smoking crack and I wish you luck. Jay Papasan, author of The ONE Thing, agrees here. You will always make a mistake and I would rather see you make it with a small deal first. Entrepreneurship is often about survival. Stay alive until you get lucky. I am one for going after a bunch of singles first then going for home runs. Plus, if you like real estate investing and want to become an operator, you will benefit by building valuable experience as you mold your track record and brand from starting with small rentals. I think that is why SimplePassiveCashflow.com has become so popular because it started small and progressed organically. Its funny that most of my coaching clients who have phenomenal W2 salaries want to start with the small stuff as if they are gluttons for punishment (I think it speaks to their character and how they achieved so much) and the folks with no track record of any success and are broke always want to swing for the fences.

If you are planning on being a passive investor or limited partner (LP) with no prior experience then there is room for some debate.

More often than not, some investors just try it on their own. They network with some lead investors/syndicators and believe in every executive summary they read. Do not be a sucker. This is not a good approach and often leads to investors getting taken by the glossy PDF and profile pictures.

“Crowdfunding websites take huge cut of your investor profits. Go directly to the source and cut out the middle man and invest with us.”

A discussion of risk and severity

The biggest problem with being a LP on a syndication is the potential of working with a shyster who takes your money. This is a very small chance of happening and can be mitigated by due diligence and creating a network that verifies characters. The risk and severity are modeled below.

Being a single family home operator has its own headaches and dangers which I have documented on past articles. It is “extremely remote” to have a $10,000-20,000 move out disaster and a lawsuit. Being a direct operator has higher returns coupled with more risk.

In my analysis of risk, a syndication (with the right people) decreases the variability of the investment performance as shown below. For example, a deal may not perform up to pro forma so instead of a 100% return in 5 years, you get 70% return in 5 years.

One Investor’s Story

In terms of my investment ideas/activity, here’s what is spinning around in my head (Note: The ideas listed below are going to conflict with one another because each path is a different approach):

1. Duplex, Triplex, Fourplex or small apartment complexes – This was the path I was going towards before we got into contact. I’ve been looking at Columbus and Cleveland, Ohio. I liked Columbus more because of population/economic growth. Got in contact with a couple agents from BP that service Columbus and I haven’t found anything that cashflows at a reasonable rate. A lot of deals cashflow at like $50-$150 per door and that’s going to be eliminated as soon as someone moves out. So while I’ve been looking for a bit, nothing yet.

2. Syndications – After coming across your stuff, I thought being a LP may be the preferred route. I get that I wouldn’t get the experience of knowing the ins and outs of RE if I did it myself, but what do I really want out of life? Do I want to spend so much time finding deals, buying, building the portfolio, or should I just be a LP and use my time for other life goals? Not quite sure, but the idea of being LP sounds like a solid approach. In any case, I won’t have accredited status for 2+ years, so I can’t even go full blast into this path unless I get in on similar deals like the ATL one you had.

3. BRRR – Open to doing any BRRR activities. I thought about this path for single-family homes, but I felt like it may be too hard to jump into BRRRing something out of state. That’s why I’ve been focusing on 1. above because Im trying to find stuff that doesn’t need a ton of work. If it needs relatively minor stuff that a PM can fix, that would be preferred before I jump into BRRRing things.

You could pursue a hybrid approach of investing in all of the above (although 2 of 3 would be more practical to not spread yourself too thin).  Again, it totally comes down to how much money and time you have. More specifically if you have a lot of liquidity then you can do more than one track. All these things are totally correct and shows that you have the big picture. Just a matter of choosing which path you want to go on. Congrats!

Starting out as LP

I recommend for investors to get their feet wet with investing in single-family properties first. Yes, I previously noted issues with single-family homes, which you will experience at some point. But there is no better way to learn and build up the war chest as a prerequisite for more scalable investments and private placement syndications. I believe that once an investor understands this and can 1) build some sort of liquidity and cash flow and 2) be able to call BS when a syndicator starts to use bogus proformas and assumptions.

Keep in mind that entering larger syndications requires serious capital. As guidance (not a rule or SEC law), let’s say you have $100,000 liquidity as a non-accredited investor and are ready to invest in syndications. You will likely only be able to do a couple $50,000 investment deals, which sounds great. But without adequate cash flow coming in from other investments you are a sitting duck for a year or two – the education process stops. So, if you encompass some experience investing or renting out single-family home rentals, are employed saving at least $30,000/year, and/or have some substantial liquidity (over $200,000), the transition would be smoother in terms of liquidity management and education progression.

If you are a tables and graphs person check this out to see a loose rule on when to make the jump to syndications.

In terms of returns, being the direct operator normally produces higher gains. Generally, 25-35% a year on paper if purchased correctly. However with my track record I consistently lost money on 3 out of ever 10 rentals, but overall I hit my anticipated $200-$300 per month cashflow per property. Throw in the chance of a disaster tenant in there like my $30,000 repair bill and a few months of vacancy and you can see how you can quickly go into the red. The only way you can protect from this volatility is to… get more properties! Something to think about in a correction if you are buying turnkey/retail properties is that you will likely be in the red with equity as unlike being a passive in a syndication you are not buying with forced appreciation.

Returns from syndications usually run in the range of 80-100% return in 5 years or 17-20% a year. This is less than being your own operator on a small rental. In terms of risk you are putting a lot of risk that the General Partners will uphold their fiduciary roles. Assuming you mitigate this as best you can by checking backgrounds and only working with those you know, like, and trust with one degree of separation, the volatility of returns is much less than the smaller rental variety. What I like about syndications is that a deal is not done unless there is a lot of meat on the bone which helps protect your equity position in a downturn – just beware of the loan terms and if it is a recourse or nonrecourse loan.

I would say 80-95% of LP investors don’t know what is truly a good deal and invest off what other LPs say (who don’t know either) and pretty pictures. How do I know well I talk to a lot of LPs so that’s why. And a lot of people only invest off the executive summary which does not include the T12 P&L (Trailing 12 month Profit and Loss statement) and rent rolls. Crazy huh?!?

Here is a shotgun spreadsheet that will get you 10% of the way there but in order to truly vet a deal you need to build your network to vet the person via conferences, masterminds, paid coaching from me which I could walk you through a deal.

Another example of trick and games being played:

What is “Cap Rate Gate?”


It’s when a syndicator manipulates the reversion cap rate to greatly influence the total returns, so they can attract investors to a deal. 

Cap rate is the market determination of how much you should pay per NOI. It is what it is and Class A is lower than Class B and Class C. An increasing Cap Rate means it’s a softer market and you are not going to be paid as much for you NOI. To be a conservative underwriter you like to see the Reversion (exit) Cap rate +1.0% higher than the starting cap rate. For example if your starting Cap Rate is 6.25% then you want to use 7.25% as your reversion cap rate.

The Reversion is a “wild-ass guess” to begin with. That is why you want to be conservative as assume you will sell in a softer market. By using anything less than +0.75% is simply “kicking the can” down the road. Likely what the syndicator will do is just blame the missed targets on the economy where it was just screwed from the get go.

See below how much it impacts the total return. This is why you need to look under the hood and stop taking the “sticker price” for face value.

What is a good IRR:

IRR as a calculation that can be manipulated by whomever does the calculation (mostly around what return a person can continually get with the cash flow they get off the property).  Moving the refi or sale up a year can bump the IRR up 20-30% like that.

I don’t really look at the IRR because its highly manipulated by sneaky syndicators. I personally look at the total return over the 5-6 year period and focus on what really matters 1) Cap Rate to Reversion Cap delta, 2) Assumed rent increases per year, 3) Assumed full occupancy.

 

What else do you look at?

Return = Cashflow + Appreciation

A lot of the stabilized deals with some value-add I go into have about 50% cashflow and 50% appreciation where half of all the gains are paid out during the life of the hold (typically quarterly) and the other half of the gains are paid out at the sale or exit of the property. A development which I tend to stay away from will likely be 0% coming from cashflow and 100% coming from the sale or exit of the property. Everyone has their own criteria what they are looking for.

 

Giving up Control for Diversify:

1) Different leads/operators

2) Asset classes such as MFH, self-storage, mobile home parks, assisted living

3) Geographical markets

4) Business plans (5-year exits vs legacy holds)

Whatever you do, try to stay as close to the investment as possible. Knowing your syndications’ operating team is the most important part of the deal. Do not invest with random people. Even if the operators are good, there is the chance that good operators do bad deals and you need to be able to be on the lookout for the “money-grab.” You want to have the experience to understand their offering at the surface level as opposed to blindly jumping on board because of the promised return on investment. And to do this you need to analyze the Profit and Loss statements for the last 12 months, rent rolls, and pull your own rental comps. These items are typically never disclosed to investors. As you can see it’s a game of smoke and mirrors. The less data they give you the less questions and the less question the more likelihood of you investing.

Crowdfunding sites are great in theory but sort of like online dating websites for syndicators who can’t find funding. Do you really want to work with these people?

Well online dating really isn’t too bad and in some ways become the normal from 2010 on but Crowdfunding sites are still in their infancy.

There is a lot of consolidation in this new space. Think of the many competiors there was before there was the Ebay or the Amazon. I stay away from Crowdfunding sites personally.

Update: Realty Shares going under – [a sign of more consolidation to come]

They were one of the biggest Crowdfunding sites however they went under because they “can’t afford to secure additional capital to fund additional investor acquisition. In other words, the marketing to get people to sign up is coming from outside sources (venture capital) and not from their business. This is typical of a tech startup. Click here to learn more about crowdfunding websites.

In the end, do not forget your end-goal. About 80% of investors who stumble on Simple Passive Cashflow want passive income. Folks start drinking the Kool-Aid, and will be financially free in 4-7 years pending taking action. Always keep your end in mind by taking a more passive approach and start designing your ideal lifestyle today.

See chart here for further visualization

“You give up a little control, you gain a lot of diversification” – Lane Kawaoka

Beware of going the Mom and Pop route

Thinking about flipping houses? Do so for the fun of it but for most high paid professionals when you factor in your hourly rate and the risk of market volatility you are better off staying at your day job..

You’re competing with the pros.. People who spend all their conscious and subconscious time trying to source the best properties and managing people correctly. You may kick butt at work but often managing white collar subordinates does not translate to leading blue collar personnel.Many deal hunters I know spend off hours taking brokers out to lunch or a Dallas Mavericks game frequently to get to the top of the list for the next deal.. Your competition also has overseas virtual assistants combing seller lists for the next deal. Not saying you cannot find a deal on your own but who are you kidding?

Lets assume at one in one-thousand deal falls into your inbox.. This is at best because I personally get over 20 deals in my inbox a day and a few syndication deals that has met their minimal deal standards (however they may be).
Where do you live?
I put great emphasis on having a deal sponsor be local to the property where they can passive birddog the property and respond to an issue.. Some investors I know say its a total deal killer not to have the person live there their whole life.
You cannot have a property management company be your eyes and ears.. Maybe this strategy has worked with 1-8 units in the past but those properties are very forgiving.. In the end ask yourself the question…. are you ok letting a $12-15 an hour person (who is constantly looking for a better gig) manage your $3M asset? No, there needs to be a general partner local or making routine trips to oversee progress.. Especially when there is other peoples money at stake!

Mom and pops – you have to love them! They go into single-family homes and scale up to duplexes, triplexes, quads, and to 8 units, 16, 20…

They read something like this and they think they get some property management ($12-$15 an hour employees) and think they are good. #BiggerPocketsBro

Here are more reasons why this path is flawed:

  1. Lending terms over 4 units and under 1 million dollar loan size is no man’s land for lending. Banks know this because amateurs do these types of loans and the failure rate is so high. Worse rates, terms, and resource debt.
  2. Mom and pops have all their money (100-400k) in one deal. This is not diversification.
  3. A few years ago me and my partner had the idea that we would just pull our money together and go into one of these under 50 unit apartments since at the time we were a still wary about trusting another person. But as we started looking for deals and running the numbers we realized that the pricing was worse than the over than 60 unit deals due to the competition of unsophisticated mom and pop investors.
  4. Mom and pop investors usually suffer from trust issues. They have severe blind spots and it is rare that they are a sophisticated well connected investor. Yes they take painstakingly care of the property and pick up trash when ever they are there but that only takes you so far.

What I like about mom and pop investors is that they eventually screw up and sell to us sophisticated investors at a discount.

I know that’s not nice :/

Commentary from other Hui Deal Pipeline Club Members:

“My near term goal (2 to 3 years) is to invest $500k to make $4k to $5k per month of low risk, real estate passive income (if still possible), I was thinking that deploying this as a limited partner over a few geographically diversified multi-family investments was a good way to get started, and to start learning.  One of your first podcasts I listened to (SPC080) was one about when you decided to move to Multi-family from Single family.  I agreed with most of your arguments in that podcast: 1) I don’t want to buy another job 2) SFH’s only scale so far 3) the return on SFH’s may not be big enough to justify the time put in (most of the turnkeys I’m looking at now have pretty low cashflow), however, it is a good small investment to learn the business. The 1st rule, or course is to not lose money…  So, therefore, following your path and taking it step by step is more prudent.”

“Many of the points you hit on are the same pain points that I am currently working through myself in regards to real estate investing. 1)  I’ve invested in SFH rentals currently and in the past, and the cash flow from these deals are great. However, the time commitment to my W-2 career prevent me from scaling this investment model. 2) Syndications are the way to go, and that’s why I’ve sought out a trusted mentor like yourself to teach me the ropes, and to bounce ideas off of to try and mitigate risk as much as possible.  It’s tough giving someone your money in hopes that they will maintain and deliver on their fiduciary responsibilities. If the opportunity is good enough for you to place your hard earned money, based on the trust I’ve developed in you, it’s good enough for me. Right now I’m building my war chest so I can go to battle on financial freedom.”

Other resources:

Here is info in Turnkey rentals or Turkey rentals.

Here is a webinar I did explaining what a syndication is: https://youtu.be/n_qsZHBOCS4

Our latest 253-unit acquisition in San Antonio (Mystery Shopping): (March 2018) – 

Post-purchase mid-rehab walk-through (March 2018) – https://youtu.be/-5h2GKZ3I58

Here is another 52-Unit deal in Iowa: https://youtu.be/rzLARk-x0JY

Post-purchase early rehab walk-through (April 2018) –

https://www.youtube.com/watch?v=bgxEV68CWpE&feature=youtu.be

More videos and webinars provided to Hui Deal Pipeline Club Members. Join here!

For actual FAQs from past deals please email [email protected] for the password.

This why we invest in B and C Class deals and stay away from Class A (typically unless its a good risk-adjusted return).

Menu of Investing Options

Click here to access the growing list of things you can investing and my personal notes on each. Let me know if you care to add to our growing information repository.

Other Resources:

Tick, Tock: Timing of the Next Downturn and What it Means For Commercial Real Estate – Yardi Article
Go Bigger! Diversify your money! Invest alongside the pros!

Four ways Sophisticated investors diversify in syndications:
1) Different leads/operators
2) Asset classes such as MFH, self-storage, mobile home parks, assisted living
3) Geographical markets
4) Business plans (5-year exits vs legacy holds). And take advantage of the overall scalability and Cost Segregation & Bonus Depreciation

*Usually I see investors place no more than 5% of their net worth into anyone deal

Things to look out for as a Limited Partner (LP):

In 2017, $1.8 trillion was raised for private placements or syndications in the U.S. I am betting this is an understatement as a lot of private placements are not reported. There are a lot of people doing this but there is very little information out there… until now!

Paperwork

Who’s the lawyer doing the legal filings with Securities and Exchange Commission or SEC?

In my experience, most of the deals I see are done by the same 4-6 people. That might just be my viewpoint of the investing universe though.

Fees

What are the fees that he sponsors/general partners/leads taking?

You don’t want someone to work for free. Its a lot of work to cultivate the network, team, and experience to even get an opportunity that works. Going through apartment investing school I noticed that the success rate was about 5-15% and that’s after 18-24 months of of constant grinding (2 hours of work everyday at least).

The main three are 1) acquisition fees, 2) annual management fees, 3) disposition fees, and other miscellanious fees that fall into those first three categories. Acquisition fees range from 0-3% of the asset price. Annual management fees range from 0-3% and based off income. Lastly, disposition fees range from 0-3% and based on asset price. If you are astute, the income will pail in comparison to the asset price so the asset management fee is the least. Don’t get tied down with percentages, convert to real works dollars.

Working directly with an operator is the best way to cut of the middle man. Check out some of the hidden fees in more traditional assets.

 

Contingency plan

Who is going to take their place if someone on the Sponsor team gets hits by a bus?

A lot of times its the boots on the ground that is going to steer the ship and that person is critical. Having a diverse team of general partners not only keeps a check and balance to drive towards the goal of bringing capital preservation and returns to investors. But it also minimizes the impact of losing one key officer.

What type of investors are being accepted and type of money?

Is it a Reg D 506B deal that accepts accredited and up to 35 non-accredited investors?

Or is it a Reg D 506C deal what is only for accredited investors?

Does the deal accept 1031 exchange money, retirement or QRP money?

Are you investing in a property or blind pool fund?

Generally speaking, I recommend investing in a specific property.

A blind pool allows a syndicator a lot of freedom to go out and find an asset. I have seen a more scams in blind pools partly because its hard to track the dollars.

“Hey man… Give me plenty of money… I’ll just flip a bunch of houses”

I like to invest in a specific property that you can vet the asset’s past performance and understand the business plan before the team picks it up.

 

Are they going to have skin in the game?

The General Partners likely have put a lot of hours into sourcing the opportunity and will put a lot of sweat equity. But beware of coming from nowhere operators who look like they have a track record.

Even though the General Partners are putting their reputation/brand on the line it is customary for the GP to put in ~10% of the total capital raise. For example, if the deal needs $4M to purchase a $20M asset, the GP will put in $400K.

Again nothing is black and white. Don’t be that annoying LP who thinks they know what they are doing because they read a few online articles on this topic. Good GPs are selecting the LPs as much or if not more than the GPs selecting the LPs.

 

What’s the minimum investment?

Typically, I see $50,000 as the minimal investment in 90% of deals I take a look at. Sometimes you can find $25,000 deals but those are typically done by newer syndicators. Asking to get a lower minimum just to get a “good deal” is annoying and can be poor form.

The GP wants to minimize the number of investors and keep it to 40-60 investors per deal. The more investors mean more headaches, filing costs, etc.

 

What’s the exit strategy?

Ask what the business plan is in terms of rehab and capital expenditure plan. Then how the sponsorship team feels about the length of hold. Again everything is a projection. This is why I like to find deals that cashflow right away. So if trouble comes due to a poorly executed project or downturn in the economy we are at least cashflowing.

What the heck does.. “a 7 pref with 80/20 LP/GP equity split”

First off don’t be scared, its all pretty simple after you learn the basics and get some practice using the language. This lingo is just there to throw off the faint-hearted.

A 7 pref with 80/20 LP/GP equity split is broken down as follows:

7 pref = 7% preferred return. You can Google the term “preferred return” but this is the amount the General Partnership/Leads/Syndicators believe they will be able to hit therefore they are going to pay investors first (Limited Partners or LPs) first. In other words, it determines who gets paid first (and second), how much they get paid, and at what points.

I call this a “hurdle” where everything below the pref gets paid at a certain amount and everything above the pref gets paid at a different set amount.

Some investors will only invest in deals where there are prefs. This is very nearsighted because 1) has nothing to do with the actual deal (vacancy, business plan, underwriting), 2) the GPs are the smartest people in the room and they have engineered the payout scheme to entice investors but extract maximum (but hopefully fair) compensation for themselves. A pref typically is paired with a not so advantageous back end split once the pref or hurdle is reached. So if a deal really gets knocked out of the park that’s when the GP’s really win. Some investors will want that alignment but in my opinion of seeing so many deals and being behind the curtain in GPs, its a constant cat and mouse game with the GPs that a LP really needs to look at it holistically.

Plus no deal is the same and the investing environment is constantly in flux.

Multiple prefs or huddle rates are known as “Waterfalls”. As an LP I don’t really like these because they are confusing and can be skewed all types of ways. Complexity usually benefits the house (GP) which is why Wall Street tries to make things confusing to un-impower the masses. Ok that might be a little of my opinion but here is what I think about traditional investing.

Sorry if this is a little random but this content can get a little intense sometimes…

Don’t go chasing waterfalls
Please stick to the “straight splits” and the “Prefs” that you’re used to
I know that you’re gonna have it your way or nothing at all
But I think you’re moving too fast… just join our mastermind.

I like very simple 70/30 or 80/20 or 90/10 splits where returns are even and very transparent.

*Caveat: you can have a deal where it seems like it is a good pref or high LP split like a 80/20 LP/GP split but the leads/syndicators can just be taking large acquisition fees and therefore paid before investors anyway. How misleading and how dare they tell you in the face that the prefs are to make sure you get paid for… BS! Again…

Other Pref/Split schemes:

  • The more you put in the better the split:
    • Investment of $50,000-$99,999: 6.0% Preferred to Investor; 75/25 split thereafter
    • Investment of $100,000-$199,999: 7.0% Preferred to Investor; 75/25 split thereafter
    • Investment of $200,000+ 8.0% Preferred to Investor; 75/25 split thereafter [makes sense because of less admin and fewer investors]
  • After a 7% preferred return is distributed to investors, the remaining cash flow will be split 50/50 between investors and the GP. Upon refinance or disposition of the property, any accrued unpaid preferred return will be paid first, then 100% of investor equity will be paid back in full. All remaining proceeds from refi or sale will be split 70% to the investors and 30% to GP. [Notice how the pref is nice but it is taking away from the upside return for the LP]
  • After the pref hurdle of a certain IRR or annual pref
    • 75% up to 15% IRR; 50/50 thereafter [Yikes]

Other Resources:

CrowdStreet’s post on the same topic

Law Insider’s library of clauses

Waterfalls not from TLC but Investopedia

Another waterfall example:

First An 8% preferred return – As the name suggests, preferred return is a profit distribution preference whereby profits, either from operations, sale, or refinance, are distributed to one class of equity before another until a certain rate of return on the initial investment is reached. The pref is stated as a percentage, such as an 8% cumulative return on initial investment; however it can also…
to all equity

Second A return of capital pro-rata to all equity

Third Above the 8% preferred return and return of capital, then 80% of cash flow to Class A Members and 20% to the Class B Member until Class Members have earned a 17% cumulative internal rate of return (IRR – The Internal Rate of Return (IRR) is the rate at which each invested dollar is projected to grow for each period it is invested. It differs from other metrics in that it accounts for the concept of the “time value of money”, or the fact that a dollar received and reinvested elsewhere today is worth more than a dollar expected…

Fourth Above a 17% cumulative IRR earned by Class A Members, then 60% of cash flow to Class A Members and 40% to the Class B Member

Waterfall terms:

General Partnership Catch Up Provision: A provision included in certain real estate partnership agreements, whereby a special distribution tier is included in the equity waterfall that allows for the general partner (GP) to “catch up” with the limited partner’s (LP) cash flow distributions. The reason for why the general partner’s distributions might lag, or the amount that must be made up with the “catch up” tier, depends on the terms of the partnership structure.Catch up provisions are most common to structures where the limited partner receives 100% of distributions until it achieves some preferred return requirement, at which point the GP receives 100% of excess cash flow thereafter until some equitable balance between the LP and GP distributions is achieved.

For example, imagine a limited partner contributes 100% of required capital to a real estate venture in return for a 12% preferred return and 50% of all excess cash flows above that threshold. The agreement states that the limited partner will receive 100% of all cash distributions until it has earned a 12% internal rate of return, at which point the GP receives 100% of cash distributions until both partners have received 50% of profit distributions. Once the GP has caught up with the LP, both partners receive any remaining excess cash flow 50/50.

Clawback Provision: A provision included in certain real estate partnership agreements, whereby a special distribution tier is included in the equity waterfall that allows for the limited partner (LP) to “clawback” cash flow previously distributed to the general partner (GP).

Reasons for including the clawback provision vary, but generally are related to instances where the GP is distributed cash flow before the LP reaches a preferred return hurdle. In the event at the end of the venture the LP has not achieved some preferred return, the GP must give back some or all distributions previously made to the GP until such point that the LP hits its preferred return.

 

Preferred Return Way

A preferred return (aka “pref”) is a great option for investors. In a nutshell, it sets a “hurdle” that an investment must return to passive investors before the operator can be paid. So on an investment of $100,000, a 7% preferred return means you will get a minimum of $7,000 annually. (Note that this not a guaranteed returned. Nothing is guaranteed in life, and in fact it’s illegal to guarantee a return. If an operator is using that word, refer them to this Investor SEC Bulletin.)

Aside from the lower risk for investors, the fact that the operator is willing to offer a preferred return is a sign of confidence. The operator is essentially saying, “we are so confident in this deal that we are willing to forgo payment until the investors get a a good return first.”

Look for Accrual

A preferred return should be accompanied by accrual of returns if the hurdle is not met. That is, if for some reason the investment is not performing and the operator cannot pay out the full 7%, the remainder should accrue on the company balance sheet in anticipation of future payoff. So on that hypothetical investment above, if the operator only can pay 6% in the first year, in the following year you should receive 8%. Below is an example of how this might look in an operating agreement.

First, to the Members holding Class A Units, pro rata in proportion to the amount of any Accrued 7% Preferred Return as of such date in respect of each such Unit as of the date of distribution, until the Accrued 7% Preferred Return of each Class A Unit is reduced to zero;

Advanced Structures

The above scenarios cover the vast majority of syndications. However, for complex deals, such as a development project staged from raw land purchase to construction to final operations, the payout structures can be quite complicated. As an investor you should take the time to understand exactly how much you get paid, in what order of preference and when. Read the documents closely, ask questions of the operator, and do your due diligence.

THIS IS NOT “EVALUATING THE NUMBERS”… THE NUMBERS ARE THE ASSUMPTIONS THAT YOU UNDERWRITE THE DEAL (ANNUAL RENT INCREASES, REVERSION CAP RATE, FULL OCCUPANCY ASSUMPTIONS

 

This is partially “Evaluating the numbers”

 

Can I go into a deal (sign PPM docs) in my personal name and transfer into a LLC later?

***We are not giving legal advice here***

Most times this is explicitly allowed in the operating agreement so nothing formal needs to happen. If its late in the year it might be smarter to wait till January 1st to make the change to minimize thus years form. The investor would need to need to hire someone to draft the transfer documents transferring the LLC interest from him individually to his LLC.  Then they would need to get the EIN. The sponsor team would need the name of the new LLC and the EIN in order to properly issue a correct K-1.

I see most LPs just going in as an individual since they are “Limited” in terms of liability and have lower legal and financial risk.

Do I get some kind of certificate? How do I know my money did not disappear?

First off stocks don’t issue physical certificates either. Private placements are the same. There are some online portals coming out that tell you your position but it is entirely to give you the warm and fuzzy feeling. In my opinion, because I searched for something for my investors, its a huge administrative waste of money I would rather not spend my money on and pass off to my investors in the form of saving my money to pay for more time for myself to find better deals – imagine that! The fees that these software developers chare are often 1-3% of the funds invested. The fact that they charge this percentage annually is absolutely crazy to be (being an early millennial) because you are paying for a subscription with a decaying virtual asset. I suspect I will be eating my words as I implement one of these systems in 2020+ but likely the price will come down faster than the cost of a rewritable CD-R drive.

Is there anything I can do to check?

One must is to go to the SEC website (called EDGAR – I don’t know what it means but I can assure you the government spent a lot of money for it.

URL – https://www.sec.gov/edgar/searchedgar/companysearch.html

You are looking for a form D for the deal. Query the LLC name…

Then you can read the docs here…

Join us on the Quest for the Uncorrelated Assets!

 

Close Menu

Free 15 minute
chat with Lane!

Our analytics tell us most people stay on this page for 78 secs…

so we figure you are a self-starter… or someone to went to school for too long.

No baseball glove needed… there is no pitch coming 😁

SEE The Deals!

Speadsheets, mindset hacks, networking opportunities and more.  Ready To Invest With us?