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Knowing the best way to allocate returns between investors and the Manager in a real estate syndication is a key element for success. Among the numerous methods for profit distribution, syndicators typically utilize two main approaches: the straight split or the preferred return.
Let’s zoom in on these two to help you determine which one is more suitable for your venture. Whether you’re just starting or have been in the game for a while, understanding both can greatly influence your syndication projects’ outcomes.
Financial Splits in Real Estate Syndication: A Brief Introduction
The straight-split and preferred return methods of splitting money have distinct features that affect how profits are divided in a real estate fund. This, in turn, impacts the overall financial landscape of your deal.
The Straight-Split Approach Real Estate Syndication Profit Distribution
In this type of syndication, profits are shared according to a pre-agreed percentage of the distributable cash from the investment entity formed as an Investor Limited Liability Company (LLC). For instance, in a 70/30 straight split, investors receive 70% of the returns while the Manager gets 30%.
The manager, often structured as its own LLC, retains a 1% ownership stake and contributes a nominal amount for its Class B interests. It may also earn fees for acquisition, management oversight, refinance, and/or disposition.
This simplicity makes it attractive for straightforward projects. However, it doesn’t prioritize investors’ returns before the Manager starts earning, which can be a drawback for some.
The Preferred Return Structure
In contrast, the preferred return is designed to be more investor-centric as they receive a specific ROI before any profits are distributed to the Manager. It minimizes risk for investors because it comes with the assurance that they get paid first.
This arrangement also incentivizes the Manager to optimize project performance to access their share of the profits. In addition, the profit distribution allows them to retain a larger percentage of ownership in the company.
A preferred return model usually involves a Class A/B structure within the Investor LLC and a separate Manager LLC, as illustrated below.
Class A
Class A members contribute 100% of the capital but purchase only 60% of the ownership interests. They receive a preferred return over Class B members and the Manager. There are two types of these returns:
- Cumulative
If the return is cumulative, any unreturned capital contributions accrue and would be made up at the next distribution event before paying current returns. Alternatively, they could be deferred until the property is sold. This means any unpaid amounts are settled from the equity upon sale after repaying the Class A capital contributions but before sharing with Class B.
- Noncumulative
In noncumulative returns, Class A members receive quarterly all the distributable cash that fulfills their preferred return, but shortfalls do not accumulate. For voting purposes, the Class A members’ percentage interests are calculated annually either as a percentage of the Class A interests or of the total interests in the company. The chosen option depends on the specific voters outlined in the operating agreement.
Class B
Class B comprises members of the Manager and/or other individual service providers. They retain 40% of the ownership interests in the company in exchange for a nominal amount. Their returns are subordinate to Class A’s, which means they get their portion of the distributable cash only after Class A members have received their preferred returns for the year. However, Class B returns may be calculated and paid in quarterly increments.
If there is insufficient cash to pay Class B members when Class A members have already been paid, Class B members can either forfeit the shortfall or have it compensated in a later distribution, such as from refinancing or sale.
Manager
In terms of returns, the manager entity earns fees but not distributions. Additionally, it does not retain ownership interest or voting rights in the company. If they are removed, the manager’s fees are prorated between them and the new manager, but distributions to its members as Class B interests remain unaffected.
Advantages of Class A/B Structure
From a real estate syndicator’s perspective, utilizing a Class A/B structure can significantly enhance an investment deal’s appeal and flexibility.
Class A/B will protect your distributions if you resign or are replaced as the manager entity because it allows you to take ownership interests. In this scenario, consider holding the Class B ownership interests in your name, a trust, or another entity you control to differentiate the Class B interests from the Manager and its members. The Manager isn’t forbidden from directly “owning” anything, and it offers liability benefits.
Furthermore, Class A/B clearly distinguishes fees from distributions. By investing a nominal amount of $1,000-$2,000 for Class B interests, you establish a cost basis that allows your earnings to potentially be taxed at capital gains rates. This can be more favorable than ordinary income rates applied to manager fees, possibly reducing your self-employment tax liabilities.
You can also allocate Class B interests to key individuals if the Class A/B is in place. Class B holds 40% of the interests, and your position as Manager empowers you to distribute these interests to individual service providers. Your attorney can draft documents designed to let you do this without needing a vote from Class A members or making those individuals part of the manager entity.
This type of allocation is advantageous for those who bring in deals or offer valuable support in a non-management role, though fundraisers should be members of the Manager. However, it may not be acceptable to loan guarantors as banks typically require them to be Manager members.
Disadvantages of a Basic 60/40 Ownership Division
A basic 60/40 ownership split, where investors receive 60% of the profits and the Manager takes 40%, might appear straightforward but presents several challenges.
If investors (Class A) receive returns on par with the Manager (Class B) from the outset, it can lead to significant tax liabilities for the latter. In such a scenario, the Manager’s 40% stake could be taxed on the total funds raised in the first year, regardless of the project’s actual value. This tax burden arises because the Manager’s ownership percentage would be viewed as taxable income from the start, which is not ideal or sustainable for long-term financial planning.
Moreover, because secondary interests don’t get paid until the preferred interests have received their returns, Class B’s income is uncertain and taxed only when actually received.
The Management Oversight Fee and its Significance
Taking a management oversight fee ensures the seamless execution of your real estate syndication project. This fee, typically 1% to 2% of the gross collected revenue or a fixed monthly amount, helps cover the Manager’s costs and compensates you for your time and effort spent managing the project. It also serves as a financial acknowledgment of the Manager’s responsibilities — overseeing day-to-day operations, ensuring timely completion of tasks, and mitigating potential risks.
On your end, as the syndicator, the management oversight fee presents positive tax implications. While it may be subject to self-employment taxes when declared as ordinary income, differentiating management interests from ownership interests could support lighter tax treatments. Class B distributions may also qualify for lower capital gains tax rates, potentially benefiting your overall earnings.
The fee also ensures consistent cash flow for the management, starting from the property’s acquisition and covering operational costs without waiting for distributions. It’s treated as a company expense paid before determining distributable cash and included in financial projections with other property expenses.
In the event that the current Manager is replaced or steps down, the oversight fee assures that:
- The fee can be split between them and the new Manager. This arrangement guarantees seamless transition and maintains Class B ownership interests held by the management team.
- You keep your distribution rights through your ownership interests acquired through past services with a nominal $1,000 contribution. These are separate from the management oversight fees you earned for actively managing the company.
Final Thoughts
Understanding the nuances of financial splits in real estate syndication can significantly influence the appeal and success of your projects. Whether opting for a straightforward straight-split or a more investor-focused preferred return scenario, the choice you make should align with both your objectives and those of your investors.
These financial structures offer different benefits and challenges, so it’s crucial to assess each one based on the specifics of your deal. Remember, there is no one-size-fits-all solution. Each real estate project comes with its own set of variables, and the right financial split will depend on factors like risk tolerance, investment goals, and project specifics.
Ultimately, mastering these concepts can position you as a knowledgeable and reliable syndicator, paving the way for mutually beneficial partnerships.
Get the best syndication legal advice on splitting money with real estate investors in your syndication from a real estate investment legal expert! One of the top syndication lawyers in the country, Shams Merchant represents clients in award-winning real estate projects across the nation. Shams is a partner at one of the real estate syndication law firms in the country that specializes in real estate syndications, fund formations, securities law, and private placements for commercial property investments and development. Shams has been featured in publications like Law360, The Business Journals, BisNow, and The Real Deal.