Advanced Deal Structures All Passive Investors Should Know
Real estate deal structures can get more advanced the more someone invests, generally there are 3 terms that all investors should understand before investing. Those 3 terms are: Preferred equity / returns, waterfall distributions, and Hurdles.
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Preferred Equity & Preferred Return
Preferred equity refers to a pool of investors who sit right below the bank in the capital stack. This means that in any scenario, the bank gets paid first, followed by the pool of preferred equity investors, and then the remaining investors and general partners.
Preferred equity investors typically have less of an equity interest in the property and more of a debt interest. This position is considered less risky, and their returns are projected to be lower unless the deal doesn’t perform as it’s projected.
A preferred return, on the other hand, is not a pool of investors but a rate of return that is given to investors before the agreed-upon split is paid out to the same pool of investors and the general partnership.
Consider a syndication looking to raise $1 million. They might offer two investment options. Investment option A has a minimum investment of $100,000 and gives you an 8% preferred return paid out as preferred equity with 10% equity in the deal. Investment option B has a minimum investment of $50,000 and gives you a 5% preferred return with 20% equity in the deal. In this scenario, investing in option A gives you more security because your preferred return is 8% and you get paid first, but you sacrifice 10% equity. On the other hand, option B investors take on more risk and get more equity in exchange for a lower preferred return.
If a deal performs as projected or outperforms projections, generally speaking more equity will equal a higher return, so investors in option B have a chance at higher returns, but investors who opt for option A are seen to have a safer investment.
Waterfall Distribution Method
A waterfall distribution method refers to where cash flows first. It's like a waterfall on the top of a mountain that pours into pools below it, needing to fill 1 pool entirely before moving onto the next.
Typically, there are four general pools in the waterfall method:
Return of capital: All the capital should be returned to investors before any distributions are made.
Preferred equity or return: As discussed above.
A "catch up" pool: A guaranteed payout to a general partnership before distributing additional returns.
Carried interest: The remaining profits are distributed among the general partnership and the limited partnership according to their equity splits.
Consider a syndication that raises $1 million from passive investors and uses the waterfall distribution method. The deal is held for 5 years but never makes a cash distribution to investors (unlikely, but it makes the example easier to explain). The terms of the deal were a 70/30 split between the limited partners and general partners with a 5% preferred annual return, with a guaranteed payout to the general partnership of $250,000.
After the property is sold and the deal profits $2 million after fees and closing costs, the first $1 million goes to returning capital to investors.
The next $250,000 goes to paying the 5% preferred return (5 years x $50,000). Since there were no cash returns during the hold period, this is all paid out at close.
The next $250,000 goes to the general partnership's catch-up.
Finally, the remaining $500,000 is split between the general and limited partnership, with 70% going to the investors and 30% to the general partnership.
Hurdles are used by general partners to incentivize performing well on the property by shifting greater returns to the general partners as the property starts to outperform certain metrics, or “hurdles”
After each hurdle is cleared, more return goes to the partners, but good hurdles should mean investors are also making more money.
Let’s say a deal starts out with a 70/30 split until the investors hit a 10% annual return. After a 10% annual return is made, the split will shift from 70/30 to 60/40, giving the general partners 10% more equity in the deal.
The next hurdle could be a 15% annual return, if the investors surpass a 15% return, the equity could shift again to 50/50.
By introducing hurdles to a deal structure GPs get paid a greater share of the profits the more successful the property is and feel more aligned with the success of the property with hurdles as incentives.