How Investors Make Money in Property Syndicates
Learn how investors and syndicators make money through the capital stack and flow of funds.
When first investing in private real estate through syndications, it can be confusing how all the pieces fit together, how investors make their money and the risks to look out for.
This article is focused on understanding how Investors and Syndicators make money through these investment vehicles - we cover the capital stack and flow of funds.
Capital Stack
Similar to investing in public companies, the first step is to understand the capital stack and how different ownership claims on the business have different return structures.
A capital stack represents the different layers of financing used to purchase a property. These layers are ranked according to their seniority and risk.
Understanding the capital stack is crucial to discern the order of payouts, the associated risk levels, and, ultimately, the risk-reward dynamics of an investment.
The capital stack is primarily composed of two elements: debt and equity.
Each of these categories can be further subdivided into various types, offering different risk and return profiles. This includes common and preferred equity, and mezzanine and senior debt.
Contrary to what you might think, common equity is the last in line for payouts. The focus here is on the upside.
Conversely, senior debt sits at the bottom and enjoys the highest priority for repayment. The focus here is on the downside.
In the capital stack, the order of priority is inverse to the order of risk.
Senior Debt
Occupying the base of the stack, senior debt has the utmost priority. This segment is typically the mortgage lender with the highest claim on the asset. In the event of default, senior debt holders can foreclose on the property to recoup their investment.
Mezzanine Debt
This follows senior debt in the repayment hierarchy. Mezzanine debt is akin to a second mortgage, carrying a higher return potential due to its increased risk.
Preferred Equity
Evolving after the Global Financial Crisis, preferred equity now operates like subordinate debt, offering a fixed return and enhanced rights in case of default.
Common Equity
The riskiest and potentially most rewarding, common equity holders are the last to receive payouts. They benefit from recurring payments and a share in property cash flow distributions, subject to the property's performance.
You can think of the capital stack like a pecking order - it's the sequence in which income and profits from the property are distributed.
From the cash flow of the property and once all the debt holders have been paid, profits are then distributed to investors.
You’ll typically see only debt and common equity in syndicated investments, but you should be aware that other instruments can sometimes appear.
Flow of Funds
From the syndication basics we covered earlier, you’ll remember there are two.
- General Partner Equity
- Limited Partner Equity
These equity types represent the ownership interests in a real estate syndication.
The General Partner (GP) manages the property and syndication, while the Limited Partners (LPs) provide the capital.
In a typical real estate syndication, a trust structure is used to manage and distribute funds efficiently, acting as a conduit for income and capital gains.
This ensures profits are passed through to investors without being taxed at the entity level, streamlining the distribution process and offering tax advantages.
General Partner Equity
The first step is acquiring the target property, funded by equity from the General Partner, Limited Partner, and usually a mortgage.
The General Partner guarantees the bank loan, meaning they are liable if things go wrong. During the deal, the General Partner earns some small operating fees.
At the end, the property is sold and proceeds go first to the bank, then to the Limited Partners, and lastly to the General Partner.
Limited Partner Equity
The property purchase is funded by equity from the General Partner, Limited Partner, and typically a mortgage. Throughout the deal, interest payments are made to the lender, and distributions go to the Limited Partners.
In the end, sale proceeds are distributed first to the bank, then to the Limited Partners, and finally to the General Partner.
If you put it all together - this is how the big picture works.
Looking at the Limited Partners who contribute capital at the start of the project, you’ll see the two primary ways investors generate returns: cash flow from distributions and sales proceeds.
Cash Flow from Distributions
Cash flow from distributions refers to the regular income investors receive from the operational income of an investment, such as rental income from a property, after expenses.
In a real estate syndication, distributions to investors typically come from the property's operational income.
This income is the revenue generated by the property, such as rental income, minus operating and financing expenses.
It's important to note that while these distributions are similar to dividends as they provide a regular income stream, they differ because they are not paid by a company but pass through a unit trust structure.
Cash Flow from Capital Events
Cash flow from capital events involves one-time financial gains from significant transactions, such as the sale proceeds or refinancing of the property, which are distributed to investors.
The sale of the property is the main capital event, but refinancing is also classified as one of these. A refinance involves taking out a new loan, usually at a lower interest rate or with better terms, to replace the existing mortgage.
Cash flow generated from refinancing is typically considered tax-free, as it's regarded as a loan rather than direct income.
When a syndication decides to sell a property, the profit made from this sale is subject to Capital Gains Tax (CGT).
However, it's not taxed at the trust level. Instead, it's distributed to investors who then pay their individual taxes.
Conclusion
Real estate syndications let you invest in bigger properties without all the work, and understanding the capital stack and flow of funds is key for investing confidently.
In this article, we covered how these two concepts interact, who gets paid first, and the risks involved.
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