We often get questions from investors wanting to know how our multifamily deals are structured.
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Multifamily Syndication Structure and What You Need to Know
Typically, our deals are LLCs – limited liability companies.
Sometimes we may create multiple entities. We may have a holding company that's registered in Texas or Delaware, for example, and then we may create a local entity that actually owns the building and that's in the state we're buying it in. Almost everyone uses LLCs, and that's what we use as well.
Another question that comes up is, “What are equity splits?”
An equity split means there are limited partners and general partners. When a syndication is done, a part of the ownership of the property, let’s say 70 percent, goes to the limited parters (the LPS) and 30 percent goes to the general partners (GPS.)
Splits can be divided in various ways, 60/40 or 80/20, for example. The general partner's part of the equity is called carried interest, meaning the general partners get equity in the deal for putting the deal together even though the investors put up 100 percent of the money for the deal.
That’s very common in syndication, and my advice for investors is don’t focus too much on the splits. The thing that’s important, aside from the operator and the deal itself, is the return – specifically the cash on cash return and the overall average return on a deal.
I find that some investors get caught up on the splits. They see a 60/40 or a 70/30 split and they think the general partners are paying themselves too much, while they’re making a 15-17 percent average annual return.
Keep your eye on the ball and don’t get too distracted with the equity splits.
They need to be in line, of course, but what’s most important is the quality of the operator, the quality of the deal, how conservative the underwriting or assumptions are and then what the returns are. The equity splits are really secondary.
Some deals have a preferred return and some do not.
A preferred return is a certain minimum of cash flow that is paid out to investors before the general partner is paid. One way to think about this is like an interest payment which is paid out first before the cash flow is split.
Here’s an example. If a syndication is a 70/30 split, 70 is going to the limited partners and 30 going to the general partners. Let’s assume the total cash investment from the investors in $100, 000 and the preferred return is 5 percent. That means the first five percent of a hundred thousand dollars, or five thousand dollars, is paid out first to the investors and then whatever is left over is split 70/30.
If the total available cash flow in one year is fifteen thousand dollars and the first five of that is paid out to the investors, that leaves a net of ten thousand cash flow. The investors would receive 70 percent of that, or seven thousand, so the investor gets five thousand out of the preferred and seven thousand from the equity split, so they get a $12,000 total payout for 12 percent cash on cash return.
Basically, the investors get paid the first money that’s available.
This sounds pretty good, but here’s why I don’t like it, and not just from the general partner’s perspective. I don’t like it from the limited partner perspective either.
If the project doesn’t go as planned, which does sometimes happen, because there’s a slow start with the units being turned over, or the property manager is struggling, then there’s not enough cash flow to fund the preferred return and it starts to accrue into the next year.
If there’s no cash flow, the operator can’t pay the five thousand preferred. It then gets tacked on year two. Let’s say in year two things start to pick up a little bit more, but there’s been a delay, so now instead of fifteen thousand dollars in anticipated cash flow, they’re at three thousand. They’re already doing better, and in year three they’re going to be good, but now they have three thousand, which means they’re going to fall short that second year, which means that shortfall is now accrued to the third year.
You see the trend.
After a while, the GP realizes they can never catch up and they’re working for free. They might decide to let it go and let the bank take over and part ways with it.
In a situation where a project doesn’t go quite as planned, a preferred return could make the operator behave in a way that is not aligned with the best interest of the entire partnership.
This is why I think a preferred return puts the LPs and the GPS on separate pages, and that’s a problem.
If we’re making a lot of money, then everyone is getting paid. If we’re not making any money, no one should really get paid.
So, I don’t like preferences and have never done them. We’re aligning the interest of the syndicator and the investor because it’s really about creating a relationship where we can all have a win-win for a long period of time.
Voting and Control
What does it mean to have control in a deal? What are voting rights?
The nature of being a passive investor (limited partner) is that you are limited and this means that you have limited liability. You can only lose your principle money, you can’t lose more than that. If there’s a total loss of the building, the bank can’t go after the limited partners. If there’s a lawsuit, it can’t go after the LPs.
So, in order to protect the LPs, the day to day operational control is limited. The law says, you’re not really driving the ship so if the ship runs ground, that’s not your fault. You’re protected. That’s a good thing, but it also means you don’t really control the ship.
When you invest in a syndication, the operation agreement outlines the rights that the LPs have and the rights of the GPs. The GPs have to make day to day decisions including things like when they sell or refinance. LPs have to vote on anything that reduces their voting rights or their equity rights in any way. Typically, that’s how these deals are structured.
Another question that comes up is, “When do I get my money back?”
There are different ways that you can get your money back and these are called liquidity events – a cash out refinance or actual sale.
Here’s an example. We have a 21-unit and we buy it seven million dollars and put a million into it then 13 months later we get it refinanced at a 15 million dollar valuation, which is great. The refinance covers the preceding loan as well as the majority of the initial investment. So we are able to return for 84 percent of the initial investment.
We get the majority of our money back, which is good for the investor because of the risks is off the table. They get their money back and can invest it again in another deal.
You get a huge cash on cash return on the same amount of money that you’re rolling over.
The other way you could get your money back would be the sale of the property, typically in five to ten years. That is normally part of the business plan so when you invest in a syndication, the plan says this is a five year hold or a seven year hold, etc. We expect to refinance or not – that’s all a part of the plan. A good operator will honor those commitments.
In our deals, if something about our business plan changes, I will poll the LPs and ask, “What do you want to do?”
At the end of the day, if the majority of our investors want something, then why am I going to resist? I need to honor my initial commitment and if I’m going to change the plan, they should provide input.
This gives you the basics of my philosophy and how our deals are structured.
You can visit Nighthawk Equity to learn more.