A Guide to Real Estate Syndications Investing

What is the debt structure/capital stack, and what do you need to understand about projected return terminology?

Many layers go into financing a deal, and this plays a large part in determining how much risk your capital is at.  

One question you should ask is what the loan to value ratio (LTV) for the deal is. The loan-to-value ratio is the amount of the mortgage compared with the value of the property.  Many people say that you want that to be in the range of 65% - 75%, as risk increases as you take on more debt. They should also explain what their debt service coverage ratio (DSCR) is, which is the ratio of their net operating income (NOI) to debt payments. Obviously, you want that number to be well above 1, and ideally > 1.25 in the first year. You will also find details of the interest rate for the financing and whether there’s a prepayment penalty and interest rate cap for floating rates.

The capital stack outlines how a sponsor is financing the deal. There are two parts of most deals, the debt portion and the equity portion. 

Those investing in the debt portion are acting as a lender.  The loan is secured by the property itself, and investors in this portion of the capital stack receive a fixed return based on the interest rate and how much they have invested.  This is a less risky position in the capital stack because you get paid first, but your upside is limited to the predetermined rate of return. The debt portion is usually occupied by institutions such as banks, but some deals offer the opportunity to invest in the debt portion as well.  If you are someone who wants predictable, regular payments, you may prefer this position. 

Most investments offered to LPs on syndications and crowdfunding deals are in the equity position, which is paid out after the debt position.  There can be various tiers within this position as well.  In this scenario, the investor is a shareholder in the property itself, and their stake is proportionate to the amount they have invested relative to that others have invested.  Your returns are determined by your share of the income generated after expenses, debt, and fees are paid. You may also be paid out a share of any appreciation value if the property is sold.  Frequently, syndicators will have different tiers for investors on the equity side, and your terms and the order of payout will be determined by this structure. 

In most deals, there is a preferred return for the equity side, often ranging between 6-10%.  This is the amount that is payed to you before the sponsor takes a cut of the profits.  Some investors will opt for a higher preferred return at a lower risk, in exchange for little or no share of the additional profits above and beyond this preferred return.  Others would like to maximize their chances for bigger returns and will opt for a smaller preferred return, but a bigger share of the upside when the property is sold (and hopefully, appreciated).  The syndicator’s pro forma will typically demonstrate projected investment returns for each class of investor, and often an investor can be invested in both classes to help mitigate risk. These investment classes will also have a different place in the capital stack. For example, investors who are solely looking for cash flow and none of the upside will have a lower position on the capital stack and receive payments first before the investors looking for capital appreciation. The lower the position on the capital stack, the less risk that investor has and is more likely to be paid first.

A note on preferred returns: The investor needs to be aware that the preferred returns ideally are cumulative, as in, when the sponsor does not distribute them over a specific period, they are still distributed later.

For example, if an investor desires a reliable and predictable return of 9%, they will be at the top of the list on the equity side for payout of profits after expenses.  However, once they have received their 9%, they will not be entitled to further profits.  Essentially, the capital was loaned at a fixed rate. Conversely, if they want upside, the equity investor can invest for growth and capital appreciation. Therefore, they may receive a lower preferred return on a regular basis (such as 6%), but will ideally reap the reward of capital appreciation on sale. 

Within the plan documents, you will likely find the details of how the syndicator plans to split the returns when the property is sold. There may be a tiered “waterfall” approach. For example, the sponsor may return 80% of the sale profits to their investors and keep the remaining 20% until a specific target return is reached. Once over that target, they may split the returns 50/50. The measure usually used to determine this target is the IRR (internal rate of return). This is not a straightforward concept to understand and is derived from a formula, but is defined as the discount rate that makes the net present value of all cash flow equal to zero. What that actually means is it’s the percent return when taking all positive and negative cash flow into account and when that cash flow occurred. For example, negative cash flow occurs when the investor makes their initial investment. If the deal returns a preferred rate of return annually and then a large return of capital investment plus profit when the property is sold, the IRR demonstrates what all of that cash flow averages into. This is a different concept than annualized return, which assumes a steady rate of return. It is also different from the equity multiple, which is the divides the total dollars received by the total dollars invested.  The equity multiple doesn't take into account the time value of money, so while it tells you how much money you will get back for the money you put in, it doesn't tell you how long it will take to get that money.  Obviously, doubling your money in 2 years is different than if it takes 10 years.

The investor must understand, however, that the IRR projected by the syndicator is only as good as the assumptions placed into the formula; therefore, it can be manipulated and doesn’t account for the risk of the investment. However, many syndicators will use this as a benchmark for their target returns.

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