How Multifamily Deals Are Structured

Category:
Syndication
|
By:
Sam Henry

One of the most frequently asked questions that we get from investors who are new to multifamily or new to investing in private placements is “How are these deals structured?”. The answer varies. There’s an infinite number of ways to structure multifamily syndications. Different sponsorship groups will have different structuring preferences. The structure can also vary from deal to deal with the same sponsor. Here we’ll explain the basic components of the deal structure with a few examples.

The Entity

All of our deals are LLCs (Limited Liability Companies). It’s the most common entity type for syndications. We form an LLC in the state where the property is located. In this LLC, we have two “Classes” of membership, Class A and Class B. Class A members are the passive investors, or limited partners, who contribute the capital. Class B members are the sponsors, or general partners, who sign on the loans and manage the investment on behalf of the Class A investors. Typically, the sponsors are contributing some amount of capital as well so they may be in both classes.


Equity Splits

The term “equity split” refers to the amount of LLC that the passive investors own vs the amount of the LLC that the sponsor keeps. Our deals are typically between 70/30 and 80/20. “70/30” would mean that the passive investors own 70% of the LLC and the sponsors own 30% of the LLC. Of course, the higher the percentage of the LLC owned by the investors, the more favorable the deal is for them. However, giving a high percentage of the equity to the passive investors may also be an indication that the deal is less profitable overall. If a sponsor can offer a less favorable equity split, like 50/50 and still produce high returns for the passive investors, then it could just be a real homerun deal. The splits alone don’t tell investors much. They should be reasonable. However, what’s more important for an investor deciding whether or not to invest their hard-earned money is the quality of the operator, the quality of the deal, how conservative the underwriting of the assumptions are, and then what the returns are.


Preferred Returns

A preferred return is a certain minimum of cash-flow that is paid out to investors before the sponsor is paid. It’s expressed as a percentage. For example, let's assume a particular syndication has a 70/30 split. 70% goes to the passive investors and 30% goes to the general partners. Let's also assume that the total cash investment from the passive investors is $100,000 and the preferred return is 5%. That means that the first 5% of $100,000 or $5,000 is paid out to the passive investors and then whatever's left over is then split 70/30 with the sponsor.


If this example deal returned $10,000 in total cash flow for a given year…

  • The first $5,000 goes to the passive investors
  • The remaining $5,000 gets split 70/30
  • $3,500 ($5,000 x 70%) goes to the passive investors
  • $1,500 ($5,000 x 30%) goes to the sponsor

Without the preferred return, that entire $10,000 cash flow would be split with the sponsor…

  • $7,000 ($10,000 x 70%) goes to the passive investors
  • $3,000 ($10,000 x 30%) goes to the sponsor

The preferred return is a major benefit for passive investors. It prioritizes their cash flow and gives the sponsor an incentive to make sure that the deal performs above the preferred return hurdle.


It’s easy to imagine perfect scenarios where everything works out as planned but what happens when things aren’t going well?


If this example deal, with its 5% preferred return, returns only $4,000 of cash flow…

  • All $4,000 goes to the passive investors
  • There’s a deficit of $1,000 that has to be made up next year before any cash flow goes to the sponsor

Even if the deal performs better overtime, it could be tough or even impossible to overcome that deficit. A deficit growing overtime can alter the alignment of interests between the sponsor and the passive investors. The sponsor might not put as much effort into operating the property because they are no longer incentivized or, they might decide to sell it early and use sale proceeds to make up the deficit. Although having a preferred return in a scenario where the investment doesn't perform as well as planned can be problematic, we value the long-term relationships with our investors more than our profits and always keep their best interest first.

Control and Voting Rights

In an LLC there are general partners (the sponsors) and limited partners (the passive investors). The nature of being a limited partner in an LLC is that you are “limited”. Your financial and legal liabilities are limited. That means you can only lose the money you invested. You can't lose anything more. Even if a fire burns the property to the ground and it's a total loss, the bank can't go after the limited partners. Even if there's a massive lawsuit, no one can go after the limited partners. In order for the limited partners to have this protection, they have to have limited day to day operational control.


There are pros and cons to this. The con is that the limited partners don't have control of how the business is being operated. The pro is that they have limited legal and financial exposure in case things go bad. The document that governs the limitations and rights that limited partners and general partners have is the Operating Agreement. General partners make day to day decisions like when to sell or refinance and limited partners typically have to vote on anything that reduces their voting rights or their equity rights in any way. When voting, investors will vote their shares. The more capital they put into the deal, the more weight their vote carries.

Return of Principal

If you’re going to be investing 25K, 50K or 250K into one of these deals, you probably want to have a clear idea of when you can expect to get that money back. There are two primary ways that you, as a passive investor, get your money back out of these deals. Either a cash-out refinance or an actual sale.


Cash-Out Refinance: The beauty of real estate is that you can buy it under market value, improve it or “add value” to it, and create equity out of thin air. After we do that work, we can refinance and pull some of that created equity out of the property as cash. When we do this, two important things happen. One is that we reduce our risk because we’ve recouped some, if not all, of our initial investment, therefore it is no longer at risk. The other important thing is that we’ve freed up that capital to be invested elsewhere thereby increasing our capacity to generate passive income.


Sale: The other event that results in a return of your initial investment is the sale of the property. Depending on the business plan this could be 5 to 10 years after its initial purchase. When you invest in a multifamily syndication, pay close attention to the sponsor’s intended holding period. The business plan could call for a five-year hold, a seven-year hold or a 10-year hold, and that will give you a general idea of how long your money will be tied up. Ultimately, the market may affect the timing of a sale. If it’s a 5-year hold and there’s a massive market correction in year 5, the sponsor may be forced to hold off and wait another year.


For our deals, we stick to the business plan that we originally presented to investors. If anything causes us to shift our plans, we’d call a meeting of the limited partners, lay out the scenario we’re facing, and our recommendation and ask them what they want to do. As sponsors, it’s ultimately our decision to make but, if the majority of our investors want something different, then we want to be responsive to that.

Sponsor Fees

There are four types of fees that you typically see in multifamily syndications: Acquisition Fees, Asset Management Fees, Capital Transaction Fees, and Disposition Fees

The acquisition fee is payable to the sponsors at closing and it's typically 2-3% of the purchase price. It compensates the sponsors for their work in finding the deal, negotiating with the seller, performing due diligence, arranging financing, risking the upfront cash needed to secure the deal, building a team of vendors, and raising the capital by bringing a group of investors together, etc.


An asset management fee is used to compensate the sponsor for the time and overhead required to manage the investment on behalf of the passive investors throughout the duration of the hold period. It is typically around 1-2% of the gross collected rents or the amount of investment capital under management.


A capital transaction fee is payable when there's a cash-out refinance which returns a portion of the passive investors’ principal. It's a major, important milestone. This fee is typically 1% of the new loan amount.


When the property is finally sold, you could see a disposition fee. This is paid at closing and is typically 1% of the sales price. It incentivizes the sponsor to maximize the value of the property in order to achieve the highest possible sales price.


This may seem like a lot of fees but, remember, the sponsor is running a business on your behalf. It’s not like a stock broker or mutual fund manager who just picks stocks and advises you on when to get in or out. As a passive investor, you want your deal sponsor to be properly incentivized to run the investment in a way that maximizes your returns. These fees help cover the expenses and overhead of running our business. The real money that sponsors make comes from increasing the value of the equity we hold in each property.


Hopefully this overview has been informative. If you have further questions on how multifamily syndications are structured or are interested in seeing our investment opportunities when they arise, please Join our Investor Group. Let’s start the conversation today.

Photo by Roman Serdyuk on Unsplash

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