Question Regarding Reserve Accounts for Syndications

[Jordan Archer]

Hi BP,

When using syndication to purchase an investment property, I understand that you would normally pay your LP's between 8% - 10% preferred on their investment, and then split the excess (somewhere between 50/50 - 70/30).

In regards to the initial reserve account you would establish for the project, how would you structure a pay back for this? Also, do the limitted partners get the same 8% - 10% preferred return on this capital as well? 

Running through it in my head, I would assume that for the first year of the project you would take the excess profit (after the 8 - 10% preferred return), and use that to displace the money in the reserve account. Once the reserve account has been displaced, and the investors have their capital back (designated for the reserve account), you would commence with the 70/30 split (or similar). Is this correct?

[Alina Trigub]

@Jordan Archer

Show me 10% pref  syndication today and I'll jump on it. :) It's been awhile since I've seen anyone offering 10% or even 9% pref. I'd say it's closer to 6% to 8% these days. Keep in mind it's not always cumulative and depends on how the deal is structured. 

The split is also dependent on what the deal sponsors decide is best for a particular deal. It could be a straight split or a waterfall. Also, if you're referring to a value add type of project, in the first few years there's typically no excess over pref. In fact the pref may or may not even be reached at least year one. 

Now if I understand your reserve question correctly, you'd want to replenish it to whatever your minimum for reserves is.  

[Brian Burke]

Reserves get distributed back when the property has sold.  Funds allocated to reserves are treated the same as funds raised for any other purpose.  The threshold to meet a preferred return hurdle includes all contributed capital, regardless of what it is used for.

[Tj Hines]

@Jordan Archer who the heck is offering a 10% pref? The norm across the board seems to be 6-8%

In regards to the excess funds in the reserve account, this should be distributed to investors once you have liquidated the asset and returned all member capital plus profit splits agreed upon. Good luck on your journey

[Jordan Archer]

@Alina Trigub Thanks for the advice. Can you give an example of how a "waterfall" split would work?

@Brian Burke Thank you for the direct answer. Very helpful!

@Tj Hines No coc of 10% anywhere today. I know demand for multifamily is still strong, but I'm hoping for higher Cap rates once the market corrects. We shall see...

[Alina Trigub]

Jordan,

Example of waterfall (only for sample purposes):
30%/70% split until 14.99% IRR is reached
40%/60% from 15% to 17.99% IRR
50%/50% from 18% and up IRR


Originally posted by @Jordan Archer:

@Alina Trigub Thanks for the advice. Can you give an example of how a "waterfall" split would work?

@Brian Burke Thank you for the direct answer. Very helpful!

@Tj Hines No coc of 10% anywhere today. I know demand for multifamily is still strong, but I'm hoping for higher Cap rates once the market corrects. We shall see...

[Ivan Barratt]

@Jordan Archer got news for you. Lower cap rates are here to stay for a while. 10 years ago, apartments were the "step child" of commercial real estate. Getting a B deal at an 8 cap is history! Today the perception of the asset class is WAY different. And, that's a mega trend that's not going anywhere anytime soon...

 Further; in Europe, average cap rates are 3.5% on A real estate while interests rates there are zero. Think that's low? Well, 350bps spread above the risk free rate is considered a healthy delta! US rates, and cap rates subsequently will do the same. After all, US is a much better place to buy real estate right now right?

You heard it here first! ;)

[Taylor L.]

@Jordan Archer I like the way @Ivan Barratt put it. Don't wait to buy real estate until cap rates start going up - nobody knows which way they're going. Just make sure any property you buy today can weather and produce good returns in a rising cap rate environment.

[John Corey]

Originally posted by @Jordan Archer:

Hi BP,

When using syndication to purchase an investment property, I understand that you would normally pay your LP's between 8% - 10% preferred on their investment, and then split the excess (somewhere between 50/50 - 70/30).

In regards to the initial reserve account you would establish for the project, how would you structure a pay back for this? Also, do the limitted partners get the same 8% - 10% preferred return on this capital as well? 

Running through it in my head, I would assume that for the first year of the project you would take the excess profit (after the 8 - 10% preferred return), and use that to displace the money in the reserve account. Once the reserve account has been displaced, and the investors have their capital back (designated for the reserve account), you would commence with the 70/30 split (or similar). Is this correct?

The responses make it clear that a 10% preferred return will be great bait to attract investors. If the project is rich enough to consistently deliver, you might choose to offer an 'above market return' to build demand.

[David S.]

Hmmm.. @Alina Trigub suggested that a pref is not always cumulative....does that mean for example if given an 8% pref, if the deal returns only 6% in year one, the 2% shortfall does not get accrued to be paid out in subsequent years before the sponsor gets their cut?...in which case one must read the PPM/LP Agreement carefully.

[Alina Trigub]

David,

Absolutely! ALWAYS read the PPM. If you don't understand something, ask the operator and/or hire your own attorney.

Originally posted by @David S.:

Hmmm.. @Alina Trigub suggested that a pref is not always cumulative....does that mean for example if given an 8% pref, if the deal returns only 6% in year one, the 2% shortfall does not get accrued to be paid out in subsequent years before the sponsor gets their cut?...in which case one must read the PPM/LP Agreement carefully.

[Paul B.]

Originally posted by @Jordan Archer:

Hi BP,

In regards to the initial reserve account you would establish for the project, how would you structure a pay back for this? Also, do the limitted partners get the same 8% - 10% preferred return on this capital as well? 

Running through it in my head, I would assume that for the first year of the project you would take the excess profit (after the 8 - 10% preferred return), and use that to displace the money in the reserve account. Once the reserve account has been displaced, and the investors have their capital back (designated for the reserve account), you would commence with the 70/30 split (or similar). Is this correct?

Are you asking about the initial money that the sponsor puts up first before the deal even closes? Closing costs, operating capital, inspection fees, etc.? I would think that the sponsor gets reimbursed immediately after the deal closes, or whenever that money is available, meaning that it would be considered an expense and only the excess of that would be allocated to the investors to satisfy the preferred return. It would be spelled out in the operating agreement though. Can anyone confirm if this approach is typical? 

[Todd Dexheimer]

Good answers from everyone above. Reserve accounts are just that, reserves. They should be held until the property sells and replenished if they are used. 

[Jordan Archer]

@Paul B.

I addition to a reserve fund, yes I was curious about these expenses as well. @Brian Burke was saying that any money invested in the project would yield the preferred return for the investor. 

Has anyone structured their deal such that the closing costs, reserve funds, inspection fees, etc. get reimbursed after closing rather than giving the LP's a preferred return on this money?

[John Casmon]

@Jordan Archer Those costs are upfront fees and are initially handled by the GP as you start incurring these prior to collecting investments from investors. You can structure the deal however you see fit, but LP returns should be based on the LP funds collected regardless of what the funds were used for as @Brian Burke stated.