How Multifamily Profits are Split. Coffee and pastry needed.

Money money money, MONEY!

Situation

The topic of profit splits in a multifamily syndication can be quite confusing and there is many to cover! Grab a coffee and a pastry and lets take this one step at a time. This article will dive into concepts about:

• >Straight equity splits
• >Preferred returns
• >Waterfall/Catch-ups
• >Cash-out refinances and Sale
• >and FEES

Profit structures and fees go hand in hand, like peanut butter and jelly or Beauty and the Beast. Fees must be structured fairly depending on the business model and the profit structure.

Let's also understand that not all deals fit into 1 mold. Syndication structures vary widely depending on the deal sponsor and the size of the deal, but its still very important to know the basics and have a strong foundation when analyzing these deals.

You can't talk about profit structures without talking about the fees. There must be a fair alignment of interests between the General Partners and the Limited Partners.

Background

There are many deal sponsors who use various methods to divide profits and structure fees. It is my duty to be an advocate for all my equity partners (you) to analyze these profit structures so that we do not invest in an unfair deal.

Fees are one of the ways General Partners (Deal Sponsors) make money in a deal. There is a significant amount of work that gets put into locating & analyzing potential profits, communicating and structuring the business plan, managing construction and renovations, and working with all members of the syndication. General Partners get compensated on the purchase of the asset, managing it, and sometimes the sale or refinance.

These are the 3 most commonly used fee structures. Any additional fees must be questioned.

• >Acquisition fee: The fee given to the General Partners for putting together the deal. It is a percentage of the purchase price (1-5% is the industry standard).
• >Asset Management Fee: An ongoing annual fee paid from property operation to manage the property. The fee gets paid out to the asset manager FIRST, before distribution of the cashflow. The industry standard is 1-2%.
• >Capital Transaction Fee: This may or may not be included. On the sale/refinance of the property, the initial investment of the investors are paid back first. Then a capital transaction fee of 1-2% is paid to the General Partners.

Assessment

Straight Equity Splits

This is the most simply and easy to understand. Sample of Industry standard equity splits include:

• >90% LP / 10% GP > Seldom seen. Sometimes used to attract new investors into their first deal or if entering a new market.
• >80% LP / 20% GP > Most Common
• >70% LP / 30% GP > Most Common
• >60% LP / 40% GP > Rare

The Net cashflow is divided as such to the GP and LP. The splits favor Limited Partners (passive investors you) and usually take the bigger piece of the pie. However, this structure does favor the GP because they are always being paid when the asset makes money.

When the property profits, everyone wins; and when it doesn't profit, everyone loses.

The fee structure for straight equity splits are generally on the lower end. That is because the GPs are already being compensated from the split.

• >Acquisition fees will tend to be 1-2%, Asset management fee at 1%, and there may not be a capital transaction fee on refinance/sale.
• >Things get fishy when you have a straight equity split with high fee structures. The GP maybe asking for too much and should be inquired for reasoning. There are some valid reasons such as deep value adds where the GP may have to manage a large amount of renovations and or take a lot of risk. Nonetheless, there has to be a legitimate reason for high fees on straight equity splits.

Preferred Returns

A Preferred return (Pref) is a very common structure used in today's commercial multifamily industry to split the cash on cash returns. A pref means the LP gets paid his profit% FIRST before the GP gets a penny.

• >Commonly used Prefs are 5-8%. The initial 5-8% Cash-on-Cash (COC) return is paid out to the Limited Partners (LP) first.
• >Eg. We raise $2,000,000 equity to buy the asset and there is a 5% COC Pref
• >This means 5% of $2,000,000 which is $100,000 must be paid to the LP first before the GP gets paid.

A preferred return acts like insurance for the passive investor or LP. Many equity structures are set so that the LP will always be paid that %. If the cashflow cannot pay it, sometimes it is paid by the cash reserves that was raised when we purchased the property, or rolled over to the next year (5% unpaid this year + 5% next year). Great model for passive investors!

There are some risks, especially for the GPs. Most of the time in years 1-2 during the renovation/value add phase of the business plan, the GPs are getting paid very little/none. Thus in order for the GP to offer a pref, the GP is taking some medium/high level of risk so that the GP can get paid later on, usually on sale of the asset.

• >WOW, the GP is offering a 9% preferred return! Wait... how much risk is he taking to make this deal work for both the GP and the LP? Are corners being cut? Are numbers manipulated wrongly? Cases like these where I usually go over the underwriting with a fine tooth comb.

Fee structures for the preferred return structure are generally in the middle to higher end. This is because the General partner is typically not getting paid till the property performs above the pref in years 2-3+.

• >Acquisition fees could be 2-5%
• >Asset management fees could stay at 1%, but sometimes we see 2%
• >There may or may not be a capital transaction fee on sale/refinance

Waterfall/Catch-up

With almost every pref comes an equity split afterwards. This structure is called a waterfall/catchup or in this analogy- a bucketfall... Lets look at this 3 part example:

• >8% Preferred return with a 70% LP / 30% GP split, and a 50%GP / 50%LP catch-up at 19% COC
• >First Bucket 8% pref: This bucket will be filled with cash first. Excess cash will be spilled over to Bucket 2
• >Second Bucket 70/30 split: The money left over will be then split 70/30 up to a 15% COC return which will then spill over to the Third Bucket
• >Third Bucket a 50/50 split at 19% COC: All the excess cashflow above 19% COC will then be split 50/50 between GP/LP!
• Deal Sponsors can keep adding more buckets if needed (if they think the deal is a home run).

Lets look at a live example:

• $193,774 was paid out to the passive investors under a Preferred return rate of 8%
• The remaining cash left over was split 70/30 between the members (LP/passive investors, and the Mgr (GP/Deal sponsors).
• If there wasn't enough cash flow available for distribution to pay out the pref, it would become a "Preferred Return Deficiency" which will usually be paid via a money reserve account or rolled into the next year.

Cash-out Refinances and Sale

Now lets look at how equity is split between GP/LP on refinance and on sale of the property. We will look at some examples.

Financial breakdown of a Cash-Out Refinance

• During a cash-out refinance, we place a new loan on the property based on the new appraised value of the asset AND we get a portion of our capital back! Typical refinances can happen at years 2-3, and sometimes year 5.
• In this scenario, we were only able to return 52% of the passive investors money back at refinance.

Financial Breakdown when Selling a Property

• As you can see during a sale of an asset, the preferred return is not applied because it only applies to the cash flow of the property.
• However, the 70/30 split applies after all the other costs have been paid out (bank, leftover LP initial investment)

Celebrate and let's do it over and over and over again!

Recommendation

Take a deep breath. Re-read the information over and over again till it makes sense. Reach out to me and I can explain any of the information in great detail.

This is how typically commercial assets are financially structured. The more you see it, the easier it gets.

When I send our passive investors a deal, one of the first things we will talk about in great detail are the returns. It is my duty to be an advocate to all our passive investors that we only invest in fairly structured deals that are exquisitely underwritten.

I know you have more questions, PLEASE ASK ME and I'd be more than happy to help!

Humans have the remarkable ability to get exactly what they must have. But there is a difference between a "must" and a "want." - Jim Rohn