The world of real estate can be a confusing place. No matter where you are on your passive real estate journey, you need to understand the meaning behind a few essential terms we use in our day-to-day.
General and Limited Partners
For starters, in syndication there are general partners and limited partners – or LPs and GPs. General partners are the operators. These are the people who find a deal, raise the money, hire the management, and run the day to day operation. The limited partners are essentially passive investors, and their exposure is limited to the amount of money invested.
So the general partner calls the shots and the limited partner doesn’t have a lot of control, but the general partner’s exposure to lawsuits is unlimited while the limited partner is protected from much of that.
IRR and AR
A lot of investors also struggle to differentiate between a couple of essential metrics we use – IRR or internal rate of return, and AR, average rate of return.
Let’s start with the average annual return, which is a simple mathematical equation. If an investment has a 10% average annual return, and you invest $100,000, you expect to get 10% over over the five year period back. So $10,000, a year times five is $50,000 that I expect to get back.
The IRR is a mathematical way of measuring the return of an investment that accommodates the inflow and outflow of money and the passing of time. The problem with the IRR is, it’s complicated to explain, especially without a spreadsheet.
The average annual return is much easier to to calculate but has its shortcomings. The IRR, though a more complicated calculations, is the more thorough way of comparing any investment – whether it's stocks, gold foil, syndications – to another.
For any given syndication, it’s fundamental to understand what kind of equity splits investors can expect to receive.
To understand equity splits, you have to remember the GPs and LPs. Even though the LPs are putting up 100% of the money, they don’t actually own 100% of the deal. They own maybe 70 or 80% and the GPC operators own the remainder.
So let's say you have an 80/20 split or a 70/30 split. The LPS – the investors – own 70% in return for putting up all the money, and the GPS -the operators- get 30% of the equity in return for doing all the work.
Those are equity splits, and they vary widely. Typically, if a deal is smaller, the equity split might be 40/60. As deals gets larger, they might be closer to 80/20. So really the investor looking at a deal shouldn’t be focused on the equity split as much as the returns that are being projected.
Preferred Returns and Deficiencies
Preferred equity or preferred return is simply where the investor gets a certain percentage paid out first, before a profit split. Think of it like an interest. If there's a preferred rate of return of 8%, then the first 8% of equity that was invested is distributed first to the investor. So let's say there's a million dollars of equity in the deal from investors. Right, then the first $80,000 of that is distributed to the investors. What's left is distributed based on the equity splits.
Investors love this because they get paid first. It’s the guaranteed part of the payment, and the profit is gravy. And that’s why operators do it – because it’s easier to raise money when investors know they’re going to be paid first.
Here is why we don't do it, have never done it, and we hopefully never will.
The deal may not go as planned. Let's say the property manager the operator hires doesn't actually do what they say they're going to do, and you lose a year or even 18 months. They have to fire that person and replace them. Now they're behind the eight ball. Meanwhile, they have an 8% return to have to pay out, and the cash flow does not exist to pay this out.
This is what's called a deficiency. That deficiency is accrued and defers to the next year, so you can't pay out the 8% that you owe to the investors. It rolls over and the second year, you owe 16% equity to the investors. Now maybe at this point, you've improved a little bit, you're able to distribute maybe two or 3%, but you're still now 30% in a hole, so that 13% now rolls over into third year.
The operator never gets out of the deficiency, and if that happens, one of two things can happen. They hand the keys back to the bank, which of course, is very bad for the investor, or they try to sell the deal, and the maximum IRR return might be achieved. In other words, it actually forces the operator make poor decisions that are not in the best interest of the investor.
For that reason, our philosophy is if we're making money, we should all make money. If we're not making money, no one's making money. This is why we don't do preferred returns.
I hope this helps clear up some misconceptions or misunderstandings you may have had around investing.
If you're interested in passive investing and want to discuss some more of these metrics we use, or get an explanation of other syndication terms we use, check out the Ultimate Guide to Passive investing.