Syndication Series #004 – How Do Real Estate Syndications Split Profits?

Michael Bjorn Huseby

Syndications are an attractive way to own real estate because investors can pool their money to purchase a larger property (or diversify across many properties). But how do the investors split the earnings from their investment? Here, you’ll learn everything you need to know about profits splits, preferred returns, waterfalls, and more. 

If you’re just getting started, check out Syndication Series #001: What Is a Real Estate Syndication? 

Parties in a Real Estate Syndication

To understand how syndications split profits, we first need to understand who participates in the deal. 

Syndications typically have two main constituents: 

  • Sponsor: This is the person (or company) that puts everything together, including identifying, inspecting, financing, rehabbing, and managing the property. The sponsor might also be called the Syndicator, the Manager, or the General Partner (GP). 
  • Passive Investors: These investors contribute capital to the syndication but otherwise don’t have many responsibilities. Passive investors are often called Limited Partners (LPs) or Investor Members.

Now, let’s explore the different ways sponsors and passive investors divide the winnings from a real estate investment. 

Option #1: The Straight Split 

One way to split profits is to allocate a percentage of all distributable cash from the property. For example, out of every dollar of cash flow, the GP might get 30% and the investors 70%.

Example 

Let’s say the syndication earns $100 after paying its operating expenses, capital expenditures, and debt service. In this case, $30 would go to the GP and the rest ($70) would be distributed to the investors based on each investor’s ownership percentage. 

In practice, the GP often invests some of its own money in the deal as an investor. In the example above, let’s say the GP invested 10% of the capital contributed by investors. In this case, the GP would end up with $37 of the $100 ($30 + (10% * $70)). The passive investors would share the remaining $63. 

Option #2: The Straight Split With LP Return of Capital Upon Sale

Option #1 is simple, but it has drawbacks. LPs might be fine splitting the monthly cash flow with the GP, but investors also want to make sure they get their money back when the property is sold or refinanced. 

To help ease investors’ concerns, many syndications say that, upon sale or refinance: 

  1. First, the syndication pays the investors until each of them gets their initial investment back.
  2. Second, the remaining profits are split between the GP and the investors. 

This way, LPs get the comfort of knowing that when the building is sold, the GP won’t earn any extra profits until the LPs have been paid back in full. 

Example

Let’s say the syndication earns $500k by selling the property. The syndication has five passive investors, each of whom initially invested $100k. 

Over the course of the syndication, each of the investors received a total of $20k in cash flow. As a result, their unreturned capital is $80k each ($100k – $20k). 

At the sale, each of the investors would get their $80k back before the profit split with the GP kicks in. That leaves $100k ($500k – (5 * $80k)) to be split between the GP and the LPs. If we use the 30/70 profit split from Example #1, the investors would collectively get another $70k and the GP would receive $30k. Because there were five investors, that means each investor received $14k in profit ($70k / 5). 

Option #3: The Preferred Return

A preferred return is a predetermined return on investment that LPs must receive before the GP gets any profits. Preferred returns are usually stated as percentages. 

A common way to structure a preferred return is to say that the GP doesn’t get any profits until investors have returned an 8% IRR on their capital. If you need a refresher, read my article explaining internal rate of return (IRR). 

If the profit split includes this sort of IRR Hurdle, the GP doesn’t receive any of the monthly cash flows until the IRR Hurdle is cleared. Because an 8% IRR means investors got all of their investment back plus an 8% return, GPs usually don’t get any profits until the property’s sale or refinancing — at this point, the investors finally get their initial investment back. Once the investors get their capital back plus an 8% return, the profit split kicks in. 

Example

Let’s use the same numbers as Example #2, with a $500k profit upon sale, except now we have an 8% preferred return. Let’s say the investment was held for exactly two years. 

Each investor invested $100,000. An 8% return on $100,000 for two years would be $16,640 (($100,000*(1.08)^2) – $100,000). That means that, upon sale or refinance, each investor is entitled to a total of $116,640 before the GP gets any profits. Because each investor got $20k of cash flow during the hold period of the investment, that leaves $96,640 to be distributed upon sale ($116,640 – $20,000). 

Here, the preferred return gave each investor an extra $16,640 before splitting profits with the GP. This exact deal wasn’t great for the sponsor, which only made around $5k for two years of work. 

As this example shows, the preferred return protects the passive investors. In Example #2, each investor received a $14k profit. Here, each investor got their $16,640 profit from the preferred return, plus an extra $2,352 from its one-fifth share of the $11,760. Therefore, each investor received a total profit of $18,992. 

Other Types of Preferred Returns 

It’s important to note that preferred returns come in a variety of flavors. 

  • Preferred returns can be cumulative, meaning that a preferred return accumulates each year. Alternatively, a non-cumulative preferred return means that an investor gets a preferred return in a given year, but if the preferred return isn’t satisfied in that year, it doesn’t carry forward to future years. 
  • Preferred returns can be simple or compounding. A five-year 8% simple return on $100k is $40,000 ($100k * .08 * 5). On the other hand, a five-year 8% compounding return on $100k is $46,932.81 (($100k * (1.08)^5)) – $100k). 

Using an IRR-based preferred return is likely the best for passive investors because it is both cumulative and compounding. 

Option #4: The Waterfall

A “waterfall” adjusts the profit split based on IRR hurdles. In each of the examples listed above, the profit split is 30% to the GP and 70% to the LPs. However, some syndications give the GP a higher percentage of the profits as a reward for stellar returns. 

For example, a syndication might use the following profit split: 

  1. 100% to the LPs until the LPs get an IRR of 8% (this is the preferred return); then
  2. 70% to the LPs and 30% to the GP until the LPs get an IRR of 12%; then
  3. 60% to the LPs and 40% to the GP until the LPs get an IRR of 16%; then
  4. 50% to the LPs and 50% to the GP.

It’s helpful to think of the waterfall like tax brackets. If the project makes a 15% preferred return, it’s not the case that the LPs get 60% of the profits in total. Instead, the LPs get all of the profits up to their preferred return, then 70% of the profits until an IRR of 12%, and thereafter the remaining profits are split 60/40. In other words, the effective profit percentage of the LPs will be much higher than 60%. 

What Profits Split Is Best? 

Option #1 isn’t great because investors don’t receive a return of capital upon sale or refinance before the profit split kicks in. However, any mix of Options #2, #3, and #4 could work well for a real estate syndication. 

Many investors like preferred returns, but you should always be aware of how preferred returns affect a sponsor’s behavior. For example, having an IRR-based preferred return protects investors from mediocre returns. However, because IRR is a time-based calculation, it also incentivizes GPs to complete projects quickly and sell as soon as possible so they can hit their IRR targets and reach their profit splits. 

Sample Splits

Two relatively typical profit splits are: 

  • Option #2: A straight 80/20 profit split applies to monthly cash flow. Upon sale or refinance, LPs receive a return of their investment before the rest of the profits are split 80/20. 
  • Option #4: Investors receive an 8% IRR before splitting profits with the GP. After the 8% hurdle, the profits are distributed according to a waterfall: 
    • 70% to the LPs and 30% to the GP until the LPs get an IRR of 12%; then
    • 60% to the LPs and 40% to the GP until the LPs get an IRR of 16%; then
    • 50% to the LPs and 50% to the GP.

How to Find the Profit Split of a Real Estate Syndication

The profit split (also called a “promote”) should be described in the syndication’s operating agreement and private placement memorandum (PPM). If you have any questions about the profit split — or any other terms — make sure to ask the sponsor to walk you through the terms. Profits splits (and other syndication terms) can get very complicated. Finding a trustworthy, transparent sponsor is essential!

Have Questions About Real Estate Syndications? 

If you’re interested in learning more about real estate syndications, feel free to reach out. I’m always happy to talk about real estate! 

Syndication Series Articles