Real estate syndication is a way for investors to pool their money together to purchase a real estate property. This allows investors to access larger deals that they might not be able to afford on their own.
There are a number of terms that are important to understand when it comes to real estate syndication. Here are some of the most common:
- General partner (GP): The person or entity that manages the real estate syndication. They are responsible for finding and acquiring properties, managing the property, and distributing profits to investors. They are often referred to as sponsors or operators. GP is responsible for the introduction and execution of the entire process from start to finish. Their main priority is flawlessly executing the business plan and giving passive investors quality returns.
- Limited partner (LP): The investor who provides capital to the real estate syndication. They do not have any active involvement in managing the property, but as business partners, they share in the profits and losses of the investment.
- Preferred return: Preferred return refers to a predetermined rate of return that is typically promised to a certain group of investors-“limited partners” before other investors or the sponsor (the entity managing the investment) receive a share of profits. This preferred return acts as a priority distribution of profits, ensuring that these investors receive a certain level of earnings before other participants in the deal. For example, if the terms of the deal specify a preferred return of 8% for the limited partners before any profits are distributed to the sponsors, LPs are entitled to receive an annual return of 8% on their invested capital. Only until the 8% return is satisfied for the preferred return investors, other investors and general partners can participate in the sharing of profit the project generates.
- Promote: In commercial real estate investing, a “promote” is a share of profits that sponsors receive once a specified level of return is achieved for investors. For instance, if investors receive an 8% return, any profits beyond that might be split 70/30 between investors and sponsors, motivating sponsors to boost project performance. The promote structure incentivizes the sponsor to actively manage and maximize the property’s performance, as their higher share of profits is tied to achieving returns beyond a certain level, benefiting both the sponsor and the limited partners.
- Acquisition fees: Acquisition fees in real estate investment are one-time charges paid to the sponsor for identifying and securing a property. For example, if an investment firm purchases a property for $5 million with a 1% acquisition fee, the fee would be $50,000.
- Disposition fees: A disposition fee, in the context of real estate investment, is a charge that investors pay to the sponsor or investment manager when a property is sold or disposed of. This fee compensates the sponsor for their efforts in managing the sale process and executing the exit strategy.
- Refi fees: If the property’s value has increased significantly since the acquisition, refinancing allows investors to capitalize on the increased value by obtaining a larger loan. This magnifies the returns on the original equity invested. In commercial real estate syndication, it is not uncommon for the sponsor to charge a refi fee when the property undergoes refinancing.
- Internal rate of return (IRR): The Internal Rate of Return (IRR) is a financial measure that calculates the potential rate of return an investment offers. It’s the discount rate at which an investment’s future cash flows match its initial cost. For instance, if an investment’s IRR is 15%, it means the investment could generate a 15% return based on its cash flows and initial cost.
- Multiple on invested capital (MOIC): The total amount of money an investor makes on an investment, divided by the amount of money they invested. It shows how many times the initial investment has been returned. For instance, if an investment of $1 million generates total proceeds of $2.5 million, the MOIC would be 2.5. The term “MOIC” is interchangeable with several other terms, such as the “multiple on money (MoM)” and the “cash-on-cash return”. If given the multiple of money (MoM) of a particular investment, the internal rate of return (IRR) can be computed using the formula below. IRR= MoM ^ (1 ÷ Number of Periods) – 1
- Hurdles: In real estate syndication, a “hurdle” refers to a minimum target return that must be achieved before the sponsor or general partner starts receiving a share of the profits. It ensures that investors, often limited partners, receive a certain level of return before the sponsor begins to participate in the profits. The hurdle ensures that investors’ interests are prioritized, and the sponsor only benefits once the minimum expected return (the hurdle) has been achieved. For example, if the hurdle is 8% and the property generates a 10% return, the 2% excess is split between investors and the sponsor based on an agreed-upon ratio.
- Waterfall: In commercial real estate investing, a “waterfall” is a structured way to distribute profits among investors and sponsors based on predetermined levels of performance. It ensures that each party receives their share before others, creating alignment and incentives in the investment deal.
- Co-investment: The practice of the GP investing their own money in the real estate investment.
These are just some of the most common terms that are used in real estate syndication. It is important to understand these terms before investing in a real estate syndication. By understanding the necessary terms and doing your research, you can make an informed decision about whether or not to invest in a real estate syndication. At Financial Peace Investing, we provide you with resources to help you learn about real estate syndication, and equip you with the needed knowledge so that you will invest with confidence when introduced to great investing opportunities in commercial real estate syndication. Feel free to ask questions through email or schedule a phone call or meeting with me. Happy investing!
