Multifamily Partnership Return Structures

Written July 5th, 2012 by

Sponsor vs. passive investor share of profits can be split using a wide variety of mechanisms.  As an investor, it is absolutely crucial that you understand the details of the investment structure.  Unfortunately, I've found that my fellow investors in deals often do not read the fine print, and more often than not are very surprised to hear how the returns are really divided!

Below are a few common structures and potential issues to understand before investing.

Sponsor % of Distributed Dollars

This is also known as an "Override" in some investor circles.  In this structure, the sponsor (aka lead investor) receives a percent of each dollar distributed from the property.

For example, if the property generates a $100k cash return per year, and the sponsor takes 15% of the distributions, then the sponsor will get $15k per year and the passive investors will get $85k per year.

There are a few potential issues with this structure:

  • % on returned capital - Some sponsors take their percent on ALL distributions, including not only profit, but also returned capital.  This may result in a much greater return to the sponsors than anticipated.
    For example, if a property generates a 15% return per year for 3 years (including capital gains) and the lead investor takes 15% of ALL distributions - then the sponsor will take 15% of the profits AND 15% of the capital, resulting in the sponsor taking 48% of the total profit!  This is not what many investors anticipate.
  • Sponsor paid even for suboptimal returns - If the sponsor is targeting 15% return per year to the investors, but only achieves 5% return per year, the sponsor will continue to get paid.  Alternative structures will only pay the sponsors if they achieve a certain performance level.

Initial Capital Accounts

In this structure, the sponsors create an initial capital account value, which is a "paper" contribution, and does NOT correspond with invested capital.  This mechanism allows the sponsor to take a percent of future profits.  It is also often used to allow sponsors to take a percent of capital gains when the property is sold for a profit.

For example, if $3M capital is raised, the sponsor may create an "initial capital account" of $300k.  This would allow ~10% distribution of profits.

There are a few potential issues with this structure:

  • Timing of capital gains - Some sponsors pay their initial capital accounts back from profits before investors share in the profits from sell.   If the profit from sell (capital gain) is less than the initial capital account, the sponsors may receive ALL of the capital gain.

Preferred Return

In this structure, the sponsors must first distribute a specific annual return to the passive investors before the sponsors can receive a share of the return.  This is typically cumulative as well, such that investors must have received this return for earlier years in the investment as well, before sponsors share in the return.

For example, if the preferred return is 10%, the sponsors must return 10% on the contributed capital (including prior years), before sharing in the profits.

This structure has many benefits for BOTH the investors and the sponsors:

  • Investors receive ALL returns until preferred return is met
  • Sponsors are more motivated - given the sponsors do not receive a portion of distributions until the preferred return is met, sponsors have a much higher motivation to perform.
  • Investors receive a return on all years - even during the transition period prior to stabilization

Summary and Recommended Structure

It is imperative that investors understand the return structure prior to investment.  Unfortunately, there is not a standard structure, and thus investors must read the fine print on investments to understand the share of the returns they will receive.  This cannot be overstated.

We believe a preferred return structure is the best for both the investors and the sponsors.  Investors will receive all distributions until their preferred return has been met.  Sponsors are motivated to achieve returns much greater than the preferred return.  For this reason, we plan to use this structure moving forward in our investments.

 

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