If you're interested in investing passively in multifamily syndications, you might be curious as to how these deals are structured.
You may have heard the terms, “straight equity” or “preferred”.
And you’re probably wondering about the trends and returns of these deal types.
That is what we're going to talk about in today's episode: Creative Ways to Structure Deals for Passive Investors
Join us in the video below!
Straight Equity
One of the ways that we commonly structure deals is through “straight equity”.
Straight equity usually looks like a 70/30 or 80/20 split, with those that bring in 100% of the money-earning a majority of the return. (Fair, right?) The rest is awarded to the General Partners who put the deal together and are managing the deal.
That’s typically the way we've done it at NightHawk Equity, and is pretty standard across the industry. We like this structure because it’s simple: ALL distributions and profits are split pro-rata.
This setup makes it easy for everyone involved to clearly understand their returns, and it’s worked well for us. That’s not to say that there aren’t some perceived drawbacks.
Especially from the investor perspective, there could be a perceived element of risk. If the deal doesn't perform, they don't really get paid.
And it's possible that – in their mind – the General Partners might get paid and they won’t. This is actually NOT true, but I can see how an investor might believe that to be the case.
Overall, we like and prefer the straight equity model.
Preferred Returns
There is another structure you might have heard of called a “preferred return” that is almost like earning interest.
In this structure, the preferred return gets paid out first. Let's say there's a bucket of $100,000 in profit and the preferred return is 7%, for example.
Out of that $100,000 bucket, the first $7,000 is then returned to the investors. Whatever is left is now split 70/30 or 80/20.
The pros from the investor is that there's a certain amount of money that they get paid first, almost like a hurdle rate. If the property doesn't perform as expected, then the investors get paid first and the general partners don't get paid anything.
In other words, the General Partners only get paid if they're at or above their projection.
From an investor perspective, it might sound like this is a good thing. And it does sound like a good thing, but here's the honest truth:
Preferred returns are NOT good for the investor, because they’re NOT good for the General Partners!
Here's what's been happening over the years: some investors have been through this where they've invested with deals that have a preferred rate of return. Well, the deal sometimes doesn't perform as it should early on, especially in the first 12 to 18 months.
And usually for good reason: the property is a value-add and maybe the construction costs are over budget, and it takes a little longer to lease up.
Under a preferred return model, there's this giant pressure to distribute cash right away. But when you're trying to build value, this pressure for a cash distribution is directly in conflict with what an operator needs to be successful!
So the general partners are in this conflict, asking themselves: “What should I do? Should I use this money and invest it in a deal so we can hit our long term goals? Or, should I distribute this cash to the investors to make them happy?”
What happens with the preferred return is this – if there's not enough cash to go around, then there's a deficiency. So if the deal doesn't go quite as planned, and there's no cash to distribute, it still accrues. You still have 7-8% accruing that year, and into the next.
The next year now, let's say it's getting a little better, but it’s STILL not enough to cover what the second year pro forma was. But now you have a deficiency from year 1, and it could play out that the General Partners never catch up.
They actually never catch up. They can never make money!
They're essentially working for free. Do you know what happens to people who work really hard for no money at all? Do they keep trying real hard, or do they maybe try a little less hard?
This is my argument against the preferred return model. It’s not good for the investor because of the misalignment. This is why we really like the straight equity deal because if we're not making money, the investors aren't making money.
And we want EVERYONE to make money!
Cash is King
Under the Straight Equity model, we aren’t pressed to distribute cash.
We always operate with a cash reserve, and this pandemic is the perfect example of why it’s important to always have that access to cash.
There’s a lot of syndicators who do have preferred returns deals that they are operating under right now, and I guarantee you they are sweating bullets under the pressure to produce distributions.
We're not distributing anything…not because we can't (we actually have plenty of money in these deals)…but we're choosing not to because we don't know if we’ll need it.
If we do need that money, it's really good to have.
If I had a deficiency and time is now my enemy, I would feel pressure to distribute that money. That’s bad; I’m going to make bad decisions under that kind of pressure.
Also, if the deficiency gets TOO big and I never make any money until the very end, I may feel that I should sell prematurely.
And I've seen that happen, too. It's a 5 year hold to maximize the value for everybody, but, you know, if I'm not getting paid for another 4 years…maybe if I consider selling and return the capital to the investors…and maybe give a little cherry on top…just so I get paid at the end.
That may be a good thing, but not may or may not be good for the investors.
Therefore the argument is that a preferred return is actually NOT aligned between the investors and the partners.
A Mixed Bag
We talked about straight equity and preferred return, but there's also a mixed approach that gives the investor certain preference.
For example, some investors really want certainty and they may gravitate towards preferred return. They may not want a giant “pop” and equity at the end.
Then there are other investors who care a little bit less about the cash flow, but they really want to build wealth, right? So they want that 20% IRR and they want to know what they’ve put in they’re going to get double back in a year. That's all they care about is these chunks of wealth that they're creating.
No two investors are alike. So some syndicators are doing a mix where they have a Class A share and a Class B share, and the Class A share has more of a preferred return.
For example, there could be just a 8% preferred return and nothing else. So these investors would get an 8% every single year, almost like interest payment. Now they don't participate in the upside, but that's OKAY because they’re making a fairly certain 8%.
The other kinds of Class B do not get a preferred return at all, but they may get that 70% split or 80% split that we talked about. So they may get cash flow if there's stuff, but they're going to get the major “pop” in the end.
So giving investors the option is something that people are starting to do. And at Nighthawk Equity, we may do the same thing. We may want to do some mix of the two, to give investors a choice.
What do you want, do you want a little bit more high degree of certainty or do you want a higher probability of profit?
Post-COVID Predictions for Multifamily Real Estate Investing
Where will multifamily syndication returns land in a post-COVID world?
Returns have gone down over the last two years, obviously by necessity as prices have gone up. That’s one reason syndicators are struggling with finding deals for investors is because we're trying to maintain that return we got three years ago.
So, it's very rare and unusual, and it should be a red flag if you’re promised deals in the 17-18% IRR with 10-12% cash-on-cash. If presented with such a deal, maybe you should be scratching your head and ask some questions around those assumptions.
The returns have been going down, and I will tell you, I think it's collectively better. If the returns continue to go down, even if they go on down to a 12-13% average annual return (for example), that's still significantly higher than anything you get in the stock market number.
And…you're not even paying taxes on that! You’re already light years ahead of the stock market return.
Now, if we can all settle for slightly lower returns we can actually buy MORE stuff. If we can buy more stuff, the investor has more deals to review, and can invest more consistently and more predictably.
I predict that the returns have to go down and will probably continue going a little bit. Not much, but the expectation should be a bit lower.
In the end, conservative underwriting and making sure the numbers work is key, in ANY climate.
Personally, I'd rather have a lower number that actually delivers than something that looks great on paper but never gets there.
Stock Market or Multifamily Investing?
If you’re curious whether you should put your money into the stock market or multifamily, I’ve got a special report for you. It’s totally free and you can check that out using the link below.
Special Report: What’s the Best Investment, The Stock Market of Real Estate?
Above all, the best investment that you can make is in your own education. Check out these other resources that I’ve created for investors interested in multifamily deals:
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