How are multifamily deals structured? Read on for insight around equity splits, voting rights, return of principal and sponsor fees!
Potential investors have lots of questions about how multifamily deals are structured, and rightfully so.
If you’re trusting us with your hard-earned money, it’s only fair that you understand your rights as a limited partner, the fees you may be asked to pay, and the timeline around getting your money back.
In this week’s video blog, I cover the 6 main components of the structure of a multifamily deal:
- The Entity
- Equity Splits
- Preferred Returns
- Control and Voting Rights
- Return of Principal
- Sponsor Fees
Watch the video below (or keep reading).
The Legal Entity
The legal entity we use to structure multifamily syndication deals is the limited liability company or LLC.
Sometimes we create multiple entities—a holding company registered in Texas or Delaware and a local entity in the state where the property is located. The local entity owns the building itself, and the holding company owns the local LLC.
Equity Splits
Equity splits vary, however, both 70/30 and 80/20 are common. For instance in a 70/30, the limited partners (LPs) get 70% of the ownership, while the general partners (GPs) receive 30%.
The operator earns this portion of the equity known as carried interest for putting the deal together, even though the investors put up 100% of the money.
My advice is to focus less on the split and more on the returns, specifically the cash-on-cash (CoC) and average annual return (AAR). If you have a good quality multifamily deal, a strong operator, conservative underwriting and a 15+% AAR, that’s much more important than the equity split.
Preferred Returns
Some multifamily syndications offer something called a “preferred return”, which means a certain minimum is paid out to the investors before the general partner is paid.
One way to think of it is like an interest payment, which is paid out first before the leftover cash flow is split based on the equity arrangement.
Let’s do a quick example.
Let’s assume a particular syndication gives investors 70% equity and the operators retain the remaining 30% as carried interest.
Let’s further assume that the total cash investment from the investors is $100,000 and that the preferred return is 5%. That means that the first $5,000 of any available cash flow that year is paid out to the investors first, and the rest is split 70/30.
If the annual available cash flow is $15,000, the first $5,000 is paid to the investors, leaving a net of $10,000. Of this remaining cash flow, the investors would receive 70% or $7,000.
In summary, the investors are paid $5,000 from the preferred return and another $7,000 per the equity split, for a total of $12,000—a 12% cash on cash return.
Pretty good, right?
Not so fast.
Challenges with Preferred Returns
The problem with preferred returns is when a project doesn’t go as planned for whatever reason. Maybe the operator is unable to execute on the original business plan, or it takes longer than planned, or there is a market correction.
Regardless of the reason, let’s assume that the available cash flow to be distributed is less than the preferred return. In that case, the preferred return accrues to the following year.
Now imagine that the situation doesn’t substantially improve, and the general partners fall short of next year’s preferred return and that accrues to the year after that.
If this goes on for too long, the general partners realize they can never catch up to the preferred return. At that point they may stop trying to turn the property around, or they may force a premature sale to get paid something—but neither scenario is actually good for the investors.
It’s my opinion that a preferred return does not put the general partners and the limited partners on the same page. That’s why we have never offered a preferred return to our investors. They’re fine with this arrangement because they get paid when we get paid and vice versa. If there is no cash flow, no one gets paid.
We’re now perfectly aligned, and that’s the way it should be.
OK, let me get off my soap box 🙂 and let’s talk about how control and voting rights are handled.
Control and Voting Rights
The nature of being an LP is that you are limited, both in liability and control. Limited liability means you can only lose the principle you invested in the multifamily deal, and you are protected by the SEC in the case of a lawsuit or a loss of the building.
Typically, LPs have no real involvement in the day-to-day operations of the multifamily property and all decisions are made by the GP.
LPs almost always have the opportunity to vote on anything that may reduce their rights in any way. And sometimes they can vote over a refinance or sale. The Operating Agreement breaks down the rights of the LPs and GPs, so be sure to read it carefully.
Return of Principal
So, HOW and WHEN do you get your principal back? Through one of two liquidity events:
- Refinance
- Sale
For example, we bought a 321-unit multifamily property in Memphis for $7M and put $1M into it. 13 months later, we refinanced the property and got a $15M valuation! This means the investors got 84% of their initial investment back.
The beauty of this is that the majority of your risk is off the table AND you can invest that money in another deal—while you continue to earn returns on the initial investment.
The business plan for a multifamily deal outlines the hold period, and a good operator will honor that commitment. Under normal circumstances, the plan is to hold the property for five to seven years—unless a market correction takes place. And if the operator is going to change the business plan, they should poll the LPs for input.
Sponsor Fees
There are five possible fees you may be asked to cover as an LP in a multifamily deal:
- Acquisition Fees
- Asset Management Fees
- Capital Transaction Fee
- Disposition Fees
Acquisition fees are the most common. Payable to the GP at closing, this fee is 2- 3% of the purchase price.
Asset management fees are typically 1½% of the gross collected rents. GPs use this money to cover their overhead for managing the property.
Though it is less common, it is not unheard of to be charged a capital transaction fee. Set at approximately 1%, this fee is due should a cash out refi return 100% of the purchase price. While we don't charge these fees, some other groups do.
The final fee you might be asked to pay is known as a disposition. This fee is a small percentage of the sale price, and it is collected when a multifamily property is sold.
Again, don’t get too bent out of shape about fees. Operators DO have overhead, and we use these fees to cover our costs. The only real money we make is on equity when we raise the value of the property.
Now You Know How Multifamily Deals Are Structured
OK, that was a lot, but it wasn’t that bad, right?
Now you know everything about how real estate syndications are structured, what some of the terms mean, and what to expect.
If you think you’re ready to start investing in multifamily real estate, let’s talk! Schedule a call with us at Nighthawk Equity and let’s get to know each other.
