How a Syndication Waterfall Works and Understanding Fees

When it comes to real estate syndications, one of the most critical aspects for investors to understand is the waterfall structure. This is what dictates how profits from a property are distributed among investors and sponsors. It’s called a “waterfall” because it illustrates how money flows from the property to the investor. Let’s review the various types of waterfall structures and how they impact investor returns.

Waterfall Structure #1: Straight Split

The simplest waterfall structure is a straight split. In this arrangement, profits are divided in a predetermined ratio between investors and sponsors. For example, an 80/20 split means that 80% of the profits go to the investors, while 20% go to the sponsors. Some investors favor this structure for its simplicity. However, it’s important to note that simplicity doesn’t always equate to the best returns for investors. In a straight split, investor money isn’t given any priority over the sponsor’s share, which means the investors don’t receive preferential treatment in the profit distribution.

Waterfall Structure #2: Preferred Return

A more investor-friendly structure is the preferred return, often referred to as a “pref.” Under this arrangement, investors receive 100% of the profits up to a certain percentage before any profits are allocated to the sponsors. This percentage, known as the preferred return rate, typically ranges from 6% to 10% per year.The preferred return can be seen as a reward for investors taking on the risk of an investment they don’t control. Essentially, it ensures that the first profits generated by the property are allocated to the investors.For example, if the preferred return is set at 8%, investors must receive an 8% return on their capital before any profit-sharing with the sponsors begins. In the initial years, it’s common for investors to receive lower cash-on-cash returns, such as 2% to 4%, due to the property undergoing renovations and improvements.

Preferred Return Accrual

An important feature of the preferred return structure is accrual. If the full preferred return isn’t met in a given year, the shortfall accrues to the following year. For instance, if an investor receives a 4% return in the first year but was promised 8%, the remaining 4% carries over, making the required return 12% in the second year. This accrual continues until the total preferred return is paid out. This structure significantly benefits investors, as it prioritizes their returns over the sponsors’ profits up to the agreed-upon rate.

The Next Step: Tiered Splits

Once the preferred return is met, the distribution moves to the next tier of the waterfall. Imagine the waterfall as a series of buckets that fill sequentially. After the preferred return bucket is filled, the excess profits overflow into the next bucket, typically involving a split between the investors and sponsors.

Waterfall Structure #3: Hurdles

One advanced method of structuring profit splits in real estate syndications is the use of hurdles. Hurdles introduce additional tiers to the distribution process based on achieving specific performance benchmarks.

For example, after the preferred return is met, a new threshold might be introduced. If the investment achieves a certain Internal Rate of Return (IRR), say 16%, the profit split might shift to a more even distribution, such as 50/50 between investors and sponsors. This is known as a hurdle rate. The rationale behind this is that reaching a higher IRR indicates exceptional performance, justifying a greater share of profits for the sponsors.

To illustrate, consider the case of a hurdle set at a 20% IRR. If the investment achieves this return, the profit split could shift to 50/50. The idea here is similar to performance bonuses in corporate settings, like Elon Musk’s bonus tied to Tesla’s performance, where exceeding high benchmarks results in greater rewards

Waterfall Structure #4: Catch-Up

Another sophisticated structure is the catch-up provision. This arrangement ensures that sponsors receive a portion of profits after investors have reached certain return thresholds. The catch-up provision ensures that sponsors are compensated fairly after investors have been adequately rewarded and their capital returned. It aligns the interests of both parties, as sponsors are motivated to ensure the investment performs well enough to reach the catch-up threshold.

The Waterfall Structure of Sunrise in Chandler

When it comes to investing in real estate syndications, understanding the profit distribution—or “waterfall”—structure is crucial. It determines how and when investors get paid. Our latest active passive investment deal, Sunrise in Chandler, features a singular and investor-friendly waterfall structure that prioritizes investor returns and minimizes risk. Let’s break down how it works.

The Basics of the Sunrise in Chandler Waterfall Structure

In the Sunrise in Chandler deal, the profit distribution follows a structured approach to ensure investors receive priority in returns:

1. 8% Preferred Return: Investors receive 100% of the profits until they achieve an 8% annual return.

2. Return of Capital: After meeting the preferred return, the next profits go towards returning the initial capital to investors.

3. 75-25 Split: Once the capital is fully returned, any remaining profits are split, with investors receiving 75% and sponsors 25%.

Transparency and Fees

It’s important to note that the Sunrise on Chandler deal features a single waterfall structure without additional hidden fees or multiple layers of profit splits. As co-sponsors, we share in the singular standard set of fees and share all responsibilities, including signing on the loan. Our profits come solely from the agreed 25% split after the return of capital.

Understanding the intricacies of waterfall structures in real estate syndications is crucial for any investor looking to maximize their returns and minimize risks. Each type of waterfall—be it a straight split, preferred return, hurdle, or catch-up—has its unique advantages and implications for how profits are distributed between investors and sponsors.

At Ascent Equity Group, we prioritize transparency and investor-friendly structures. Our latest deal, Sunrise in Chandler, exemplifies this commitment with its clear and straightforward waterfall structure. By offering an 8% preferred return, ensuring the return of capital, and then applying a 75-25 profit split, we aim to align our interests with those of our investors and provide substantial, reliable returns.

Understanding these structures helps you make informed decisions and protects your investments. We believe in maintaining transparency about fees and profit splits, ensuring you know exactly how and when you’ll receive your returns. With our hands-on approach and dedication to minimizing risk, we aim to build trust and deliver consistent value to our investors.

If you’re ready to explore the potential of real estate syndications or have any questions about how these structures work, we’re here to guide you every step of the way. Investing with confidence starts with knowledge, and we’re committed to providing you with the insights you need to succeed.

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