How Limited Partners Make Money in Private Real Estate Syndications
What actually happens when you invest as a Limited Partner in a private real estate deal?
Typically, as an investor, you are purchasing an interest (or share) of an entity that will own a property. The cash (equity) the partnership receives from investors is used to purchase one or more properties. The purchase costs are similar to any real estate purchase. The General Partner (sometimes called the Sponsor or Operator) uses the funds for the down payment, closing expenses, reserves, and renovation funds.
The General Partner’s job is the following:
At Endurus Capital our job is to do the homework on the best markets and sub-markets within the market, understand what is happening in those cities and states, find and underwrite the deals, negotiate on the deals, put up earnest money and upfront costs once a deal is under contract, complete the due diligence inspections, raise the money and find the debt, execute on the purchase, operate the asset, manage the renovations, then sell or refinance the asset at the most opportune time.
How do the Limited Partners get paid?
1. Cash flow from the income. The Limited Partners are going to typically get a 5-8% preferred return, which simply means they get paid 5-8% annually on their investment before the general partner is paid. Then, they share the cash flow on a split (typically around 70% to the LP and 30% to the GP).
2. Equity payment at the sale. Once the property sells the LP’s get paid their split. This split is pre-determined and is typically around a 70/30 to 80/20. This simply means that the LP is paid 70% to 80% of the overall profit.
Here is an example of what that could look like assuming an investor invests $100,000 into a syndication:
The investor sends $100,000 to the purchasing entity account, and property is purchased.
Year 1: The property cash flows 5%.
· The investor gets 5% distributions
· $5,000 cash flow
Year 2: The property cash flows 7%.
· The investor gets 7% distribution
· $7,000 cash flow
Year 3: The property cash flows 9%
· The investor gets 7% pref
· The investor gets 2% to make up for the 2% miss in year 1
· $9,000 cash flow
Year 4: The property cash flows 10%
· The investor gets 7% Pref
· The investor gets 70% of the additional cash flow ($2,100)
· $9,100 cash flow
Year 5: The property cash flows 11%
· The investor gets 7% Pref
· The investor gets 70% of the additional cash flow ($2,800)
· $9,800 cash flow
Year 5: The property sells
· The investor gets 70% of the profit at sale and their original investment back.
· Let’s call this a 60% return
· $60,000 profit paid at sale
· $100,000 original investment paid back
So here are the returns: The investor gets a total of $39,900 in cash flow over 5 years and $60,000 in cash at the sale. The Total profit is $99,900 in 5 years with a 100,000 investment.
As we all know, compounding is a powerful tool. Take a $100,000 investment and invest it into a 5-year hold and reinvest it over and over again. Here’s what it could look like:
Year 1-5: $100,000 turns into $200,000
Year 6-10: $200,000 turns into $400,000
Year 11-15: $400,000 turns into $800,000
Year 16-20: $800,000 turns into $1,600,000
Year 21-25: $1,600,000 turns into $3,200,000
If you can invest $100,000 each year for the next handful of years, your money can grow dramatically in a relatively short period of time.*
Due Diligence for the Limited Partner
As an investor, you should be analyzing the sponsor as much or more than the deal itself. Look at a deal’s risk by the most to least. The greatest risk is a sponsor with no experience, no team, no track record, no alignment, no reporting. The more of each, the better. At a minimum, look into the sponsors:
· Experience in the specific strategy / market: Ask the sponsor how long they’ve been in business, how long they’ve been in the specific asset class (ie, Multifamily), how long they’ve been investing in the market. The more experience, the less the risk.
· The Leadership team: Who’s on the team, what’s their experience? Are they in-house employees or contractors?
· Track record: Beyond how long the sponsor has been in business, understand how many deals they’ve bought and sold. If they hold long-term, ask for their cash flow and refinance track record. Also, find out how their current deals are going. Make sure they give you the entire list and not just the good ones.
· Alignment: The GP should be investing in the deal and signing on the loan. We typically will invest 5-10% of the equity and don’t hesitate to sign on the loan, even signing a personal guarantee.
· Reporting: Ask about the reports. Endurus sends monthly reports with the P&L statements. Look for GP’s that at least send quarterly reports and financials.
· Fees: The more the fees, the higher the risk for you. Endurus charges an acquisition fee and an asset management fee. Some sponsors charge loan guarantee fees, finder fees, assets under management fees, capital transaction fees, and distribution fees.
Meet the sponsors in person if possible. You cannot eliminate risk from any investment, but doing some basic homework will easily illuminate red flags.
Digging Into the Deal
When you’re looking at the deal specifics, there is a lot to look at, but it can be narrowed down to a few main elements:
1. Location: Look for locations with population growth, low crime, and good access to the property. For less risk, invest in newer A-class assets in A-class locations. The highest risk, highest reward will be the C class buildings in C class locations with a value-add play. A class is the most recession-resistant, while C-class will get hit the hardest.
2. Financing: I’ve written about this before here: Financing. It’s quite simple, fixed rate debt with a low LTV and a high debt service coverage ratio carries the least risk. Floating rate bridge debt with Mezzanine or pref equity on top of it carries the highest risk.
3. Cash flow: Look for properties that have real immediate cash flow. Properties with no cash flow can create excellent returns, but they carry a greater amount of risk. Some sponsors will raise a bunch of extra money for reserves and then pay you “cash flow” out of the reserves. This is not real cash flow and should be seen as a high-risk strategy.
4. Underwriting metrics: Conservative underwriting is what everyone is after, but how can you tell if it’s conservative? Look for a few items:
a. Cap rate on exit: Compare the cap rate on exit with the current cap rate in the market. Note the current market cap is not based on the purchase but based on all of the sales in the market. The cap rate on sale should be equal to or greater than the current market cap rate.
b. Rent comps: If it’s a value add, make sure the rents are achievable and that the sponsor is using comps that are like the asset you’re investing in.
c. Reserves: The #1 reason businesses fail is the lack of capital. Make sure there is 4 – 12 months of principal and interest mortgage payments set aside (4 months for a stable non-value add, 6 months for a light value add, 9 months for moderate, and 12+ months for a heavy value add).
5. Stress test: It’s important to understand what the breakeven occupancy is, what happens if interest rates go up (if rates are floating), what happens if the sales cap rate expands, what happens if the length of the investment extends, etc.
Investing in a syndication is quite simple. Don’t overcomplicate it. Get to know a few sponsors (General Partners) that you can trust and that fit your goals, study their deals, and then pull the trigger. Use this blog and our other blogs as a guide and you should be set up to be successful as a limited partner for years to come.
*Performance of a syndication is not a guarantee. Investing comes with risks, and past performance doesn’t mean future success. The returns stated in this article are for educational purposes only and are not real or promised returns by the author or Endurus Capital. Each investment comes with risks that could result in a total loss of your investment.