We’ve done a lot of content about the basics of passive investing, but what is the structure of these investments, and how do passive investors actually make money? Lon Welsh is back to tie together the building blocks we’ve touched on, and explain who does what when it comes to passive investing.
- Listen to the podcast “#400: All the Benefits of Real Estate without the Headaches: The Perks of Being a Passive Investor” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
What Are the Different Roles in Passive Investing?
The basic structure of both a syndication and fund is two to three general partners (GPs) who run them, and a lot of limited partners (LPs) who bring the cash. It’s a classic division of labor where someone makes all of the effort without a ton of cash, and someone else puts in almost no effort but supplies the cash.
The GP is responsible for:
- Finding the project
- Doing the due diligence
- Getting the property under contract
- Arranging the financing
- Doing the inspection
- Negotiating the deal and closing it
In a value-add project, those responsibilities expand to:
- Organizing the general contractors
- Managing bids
- Managing paperwork for cash draws out of the bank
- Supervising the work
- Hiring and managing a property manager
- Leasing up the asset
- Arranging for a refinance at the correct time
- Determining the metrics of when to sell
- Managing the whole asset disposition process
Most importantly, GPs are guaranteeing the loan, which means their neck is on the line if something goes wrong.
Meanwhile, the responsibility of the LP is to write a check, send it in, sign some documents, and cash the checks they get in return. For passive investors, this is a great division of labor. It’s similar to investing in the stock market where you don’t have to do anything beyond writing a check while the employees of the company do the actual work.
One way to look at the difference between a syndication and a fund is to see a syndication as investing in Apple, where the company does the work of making money. On the other hand, a fund is like sending your money to Vanguard and having a team of Harvard MBAs picking out stocks in a mutual fund.
How Are Investors Paid in a Syndication or Fund?
Say you’re investing as an LP in a luxury apartment building in Dallas, and the property just sold. There’s a bunch of cash coming back, and it needs to be divided up. The Operating Agreement and other documents will lay out all of the formulas used to determine how this will happen.
Understanding a Preferred Return
The LPs are given a preferred return. For the fund Ironton Capital just launched, the preferred return is 6%. Of the cash that comes out of the project each quarter or year, the LPs who provided the most capital receive this return.
Preferred returns are generally between 5%-10%. The reason for this is because if you were to ask a typical investor what they’d do with their money outside of passive investing, they would likely respond that they would put it in the stock and bond market. Over a long period of time, they’ll probably make around 6% a year. Preferred returns are based on this typical stock and bond market return.
If it’s a development project, there may be zero cash flow until the third year or so when the building is completed and leased up. That period of time is cumulative, meaning if the preferred return is 6%, LPs are owed 18% at the end of that three-year period. Sometimes, this amount compounds and LPs get interest. That interest won’t make much difference because of the relatively small time period, but it will be spelled out explicitly.
After LPs receive their share, there’s a catch up percentage paid to the GP, which is 1.5% annually for Ironton Capital’s fund.
What’s a Waterfall?
Let’s say the apartment building makes a 25% return. First, 7.5% is allocated (the preferred return and catch up percentage).
Between 7.5%-20% of that return, you’ll typically see an 80/20 split, with 80% going to the LPs, who are paid first.
After that 20% is allocated out, there’s a 70/30 split, which incentivizes the GPs to manage the project really well. The better it’s managed, the more they get paid. If they have average results, they’re paid worse. LPs will usually get paid at least as much as the stock and bond market. Though, of course, nothing is guaranteed for total returns.
Learn More about Passive Investing
Preferred returns and waterfalls are the two biggest differences between active and passive investing. They help create a structure that ensures that the better an investment, the more the GP gets paid. This motivates them to find a great investment and work hard to get the best results.
To learn more about the specifics of passive investing, check out this webinar hosted by Lon and me.