Understanding a Syndication Waterfall

Becoming a passive investor in a real estate syndication is a great way to enjoy the benefits of real estate ownership without having to deal with Tenants, Termites, and Tantrums.
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But understanding how the money flows in a syndication deal can be confusing at first. We use the metaphor of a waterfall because earlier buckets have to be “filled” before money can flow into later buckets creating a hierarchy that protects investors by ensuring that passive investors get paid first, while at the same time providing motivation to the general partners to operate the deal so as to provide the highest possible returns so that they can receive their “promote” which is the term for the payments that are received for surmounting the return hurdles.
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This video will outline a sample distribution waterfall that will describe how cash flows back to investors in a common syndication model. This waterfall is similar to the majority of syndications that you are likely to come into contact with, although there are sure to be key differences. You will want to carefully read your legal documents with the assistance of legal counsel.
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Unfortunately, the company agreement in your subscription package will probably explain the waterfall in legalese, much like this one does.
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On the other hand, some company agreements are easier to understand, like this one.
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Believe it or not, the two previous documents and the first diagram all describe the same waterfall!
Let’s break down the legalese into plain English.
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Let’s take a look at this sample waterfall
In this example, investors receive a 7% preferred return on invested capital. Most syndications pay distributions quarterly if cash in excess of the current and anticipated future needs of the business is available. If you invest $50,000, that would be $875 per quarter which is not a bad rate to receive while you wait for the project to progress.
This preferred return may be cumulative and also compounding
• Cumulative means that if distributions are missed, there will be catchup payments
• Compounding means that interest is to be paid on missed distributions

This 7% preferred return is referred to as the first hurdle, because, the deal sponsors can’t begin to return your capital until the entire 7% preferred return has been paid.

Second, the investors receive 100% of their invested capital. Usually this happens largely through a refinance or at the sale of the property. Distributions can also count towards the return of capital, but only if they are over and above the 7% preferred return and after interest has been paid on any missed distributions.

At this point, many investors wonder what happens when all of their invested capital has been returned. They may wonder if they are still “in the deal”. Worry not. Generally, after return of capital, distributions are split between the limited partners and the general partners.

In this example the split is 70% to the limited partners and 30% to the general partners up to the second hurdle, which in this example is 17%.

At this point the deal has done quite well – congratulations on the decision you made by entering into this syndication as a limited partner! But, the fun isn’t over yet. Distributable cash above the second hurdle will be apportioned 50% to the limited partners and 50% to the general partners.

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At this point, investing in a real estate syndication probably sounds like a lot of fun, and it can be. However, syndication is not for everyone. You will have to take the time to show the sponsor that you are a sophisticated or accredited investor. Also, investing involves risks. You can lose part or even all of your invested capital. Also, your investment is illiquid, meaning that you may not be able to cash in your shares for several years, until the property is sold.

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On the other hand, if you are able to meet the above requirements and you are interested in diversifying your portfolio out of the stock market, real estate syndication can provide outstanding returns without exposing you to the volatility of the stock market. Thanks for watching, don’t forget to “like” and “subscribe” and hit the bell to be notified of future videos.