Are you investing in a real estate syndication or planning to raise capital for your own deal? 🏢💰
In this video, Stephen Morris breaks down the often-misunderstood mechanics of real estate syndications. Whether you are a Passive Investor (LP) or a Sponsor (GP), understanding how the money flows—and how the taxes are allocated—is critical to your success.
We dive deep into the “Distribution Waterfall,” explaining exactly who gets paid first, how “Preferred Returns” work, and why your cash flow might look very different from your tax return. 📉
In this video, we cover: 🤝 Sponsor vs. Investor: The difference between the “GP” (Sweat Equity) and the “LP” (Cash Equity). 🌊 The Waterfall: How cash distributions flow through tiers (Return of Capital → Pref → Promote). 📊 The Split: Why established developers command 50/50 splits while new sponsors might offer 70/30. 🚫 The Tax Trap: Why “Cash Flow” and “Taxable Income” are NOT the same thing (and how to read Section 704 of your operating agreement).
💡 Need help structuring your next deal or reviewing a syndication agreement? Contact us at Advise RE to ensure your tax strategy is aligned with your investment goals.
Transcript:
Hello everybody, welcome back. Stephen Morris here with Advisory. It’s been a little while since we’ve done our last video. We’re back at it and here to share some knowledge on the best practices around real estate investing and tax outcome. Let’s dive into an area that I think is often misunderstood by a lot of investors and how cash flow distributions and the general nature of syndications work. So for example, you’ve been pitched a deal or you’re pitching a deal, which we’ll talk about in another video and how that works. But in either case, whether you’re being pitched to or you’re pitching, you’re looking at the economic outcome of that particular investment. So for example, if you’re evaluating a deal, let’s say it’s in Georgia and a developer is proposing a structure where he’s looking to raise $10 million of equity, he’s gonna borrow another $20 million of construction financing, and he’s looking to hopefully build some large apartment complex, which would spin off lots of returns and lots of cash flow. And after a refinance, all the investors get their money back and then the cashflow split and distribution. What does all that mean?
And so being able to analyze those types of deals will greatly help you whether you’re investing in someone else’s deal or whether you’re planning to pitch that particular deal to your investors as you start to raise your own rounds of syndicated deals. To that end, let’s talk about two terms that relate to real estate syndications. There’s always two sides to the equation. The first side is going to be the sponsor. That’s the GP or the general partner, the person who’s primarily responsible for all the activities related to the development. They are the ones that source the deal, they’re the ones that execute on the business plan, they’re gonna put in all their sweat, their time, they may put in some money as well, that’s very common. And generally speaking, they’re the ones responsible for all the stuff that happens in the deal. The other side would be the investor, okay, or the LP. And the investor’s responsibility is pretty much two things. One, write a check. Two, cash a check that’s bigger than the one that they received, hopefully. So how do these deals work? The sponsor is primarily looking to invest their time, their effort, their sweat in order to receive an outsized return on their expertise. So for example, if you’re a developer, you’re gonna put in all the time you spend in learning how to acquire a deal, how to hire the right help to build your property, how to put in the right management in place, and also all your connections within the financing world in order to achieve that refinance that hopefully will cash out most of your investors. So what they’re basically looking to do is contribute their time for a profit or return or ownership or an equity interest or something along those lines.
The investor on the other hand would like to earn a return as well, hopefully outsized, which is why a lot of times, the valorables are very attractive because they offer the highest returns for the most risk. And that’s pretty much it. They don’t wanna deal with whether or not the contractor shows up on time to the job. They don’t wanna deal with property management issues. They don’t wanna deal with all these other technical details. They’re leaving that to the sponsor and gonna reward the sponsor for handling all this type of stuff. So with that in mind, how does it all work? How does the cash flow get split? What are some events that might trigger cash flow? And how are some of the ways deals kinda shake out? So a typical deal, and I’m not saying all of them are like this, is going to be something along the lines of the sponsor is gonna put in some amount of equity, maybe five, maybe 10, even up to 20% of the equity. The investors are going to put in the rest. They’re gonna put in anywhere between 100% all the way down to maybe 80% of the equity.(…) After the real estate investment has achieved a certain outcome, for example, the completion of the property, it has CFO and now it’s fully leased and ready for refinance, the refinance proceeds are going to follow some sort of distribution waterfall. And so a waterfall is essentially, if you can imagine it, there’s this waterfall kind of flowing down. And as the waterfall starts to hit certain points, the money or the water, starts to flow in different directions. Think of that water as money.
And so when the waterfall hits this point, that might be a trigger for a split. Okay, so how does this work in real life? The investors put up all the money, and after a couple of years, they get the money from the refinance, but they don’t just get their invested capital, they might get some sort of concept of a preferred return. So for example, let’s say that the preferred return is set at 8% first rate, okay, or preferred return rate. And so after two years, and if we’re calculating on a simple basis, not compounding, then the investors would have a priority to the cashflow at this point in the waterfall of a million plus 80,000 for the first year plus 80,000 for the second year, totaling a million, $160,000. At that point, it’s possible that the waterfall ends right there. It’s a very simple split after the investors get their money back plus an 8% preferred return. Then the split forever after that on this next tier goes, 70% to the investors, 30% to the sponsor. That could be a potential way. Alternatively, you can make it more complicated. I’ve seen all sorts of deals get really, really complex. And the second tier is okay when the investor achieves a certain amount of money over this amount of 10% or 12%, then the split gets better for the sponsor, for example, and maybe it goes 60, 40 or 50, 50 thereafter, and so on and so forth. What I wanna convey to you is that there isn’t really a right way to do these type of deals. The function or the amounts that are set for preferred returns, the amount of the split, is going to be a function of several things. Number one is the competence of the sponsor. If it’s a brand new person who just got into real estate, hasn’t really proven themselves, guess what? They probably can’t command much of the premium. Maybe their splits are gonna be lower. They’re gonna have to give more to the investor, make the investors feel confident that they’re really taking on this risk. And when they’re taking on this risk, they gotta be able to make more money from the deal.
Alternatively, let’s say you’re a very proven developer. We know several of them here in Los Angeles. Some have built fantastic shopping centers and malls and office buildings. And those guys can pretty much walk into any room and say, “Here’s the deal. Take it or leave it. I’m gonna take a huge chunk, but you know I’m a proven quantity because I bring so much to the table. I have so much experience. I have tons of developer relationships. I have construction companies that I can call at any time and I happen to know the city. So I can get things through a lot quicker. I’ve lowered the risk. And because I’ve lowered the risk, you as the investor are gonna make less, but it’s more guaranteed or it’s more of a sure outcome than had I been brand new. So the ability for you to negotiate these deals, whether you’re the sponsor trying to convince investors, or if you’re the investor trying to convince the sponsor to give you more is gonna be a function basically of this. When there’s more money chasing deals, sponsors have more power. When there’s more sponsors chasing money, the investors have more power.(…) One other thing I wanna bring up to you are tax considerations. So when we’re looking at ultimately the partnership agreement that’s gonna happen between the sponsor and the investor, there’s gonna be two concepts at play. There’s gonna be a concept of where does cash get distributed, okay? And how. That follows that waterfall structure I was telling you about. So for example,(…) after the first, the 8% preferred return, the investors get a million 160, and then after that it goes 70, 30. Pretty easy to understand. Every single time money is gonna leave the property account to go to the investor and the sponsor, it’s gonna follow that model. $100 gets earned and distributed, 70 to the investors, 30 to the sponsor. Very, very straightforward.(…) Well, what about the tax consequences?
A lot of confusing things that a lot of investors tend to misunderstand is this concept of cash flow distribution and tax allocation. Now, because we’re setting these things up as partnerships, the concept of how taxable income is allocated also plays a very important role. And this is also a negotiation point as well that a lot of potential sponsors and investors have to wrestle with. What are some key things that they’re looking for?(…) Sponsors a lot of times want depreciation, right? And the depreciation results in fantastic tax deduction. And I’ve seen deals where they would allocate, let’s say, the result of a full cost segregation study to the sponsor because the sponsor can immediately take advantage of those tax deductions. Whereas maybe the investors, because they’re limited by the passive rules, aren’t able to do so. That’s one potential outcome. There’s credits, you install solar before the end of this year.(…) Then those solar credits could potentially be allocable to one party or the other. So those are also other considerations that you’d have to think about as you’re negotiating a deal. And some of these tax outcomes generally have to be reviewed with your own accountant as well to see if the outcome of the tax allocation, forget about just the cash for a second, is also in accordance or in agreement with what you’d like to see as an outcome of your investment.
So also, generally, before you invest in a particular real estate syndication deal, what I’d highly recommend is that you look at the distribution section of an operating agreement and also the income allocation section of the operating agreement. You’re gonna see things in there like in accordance with 704 and all those sort of things. When you start seeing those numbers, especially at co-section 704, then you know you’re kind of on the right track here in terms of how income allocation is gonna happen within the partnership structure. And then ultimately, if you don’t understand it, you’re gonna have to call tax us right here. We’re happy to explain to you how these tax allocations and cash flow distributions work out. And you can ultimately see what the investment outcome is going to be. So anyway, if you find this helpful in your next investment opportunity, then please feel free to contact us here and we’ll be more than happy to assist you on your next transaction. Thanks so much for watching.
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