The Pros and Cons of the Two Most Common Investment Tiers
Joe Fairless and Theo Hicks provide real estate investors who are learning the syndication ropes with valuable insight and advice via their Syndication School podcast. Recently, they have delved into the advantages and drawbacks of offering two investment tiers to passive investors.
The most common type of compensation structure offered with multifamily syndication deals is a preferred return system with a profit split. As an example, an investor may receive an 8% preferred return. On top of this, the investor would receive a 50% profit split on additional returns. Of course, there are variations to the return and split based on the IRR threshold.
While this compensation structure is profitable and appealing to many investors, it is a one-size-fits-all tier structure. Individual investors may have different investment objectives than accredited or more sophisticated investors. Specifically, one type of investor is looking for cash flow or a return that beats the stock market’s return. The other type of investor wants a lump sum return within a few years without the need for regular cash flow. When you offer a one-size-fits-all investment structure, your investment opportunity may not be appealing to a full block of potential investors.
To appeal to the broader range of investment objectives, some syndications are now offering Class A and Class B ownership options. With pros and cons to both options, it is important to understand more about them. Class A investors notably take their return behind the investment’s debt. This means that the property’s debts are paid, and the Class A investors then take their cut. Because of this, Class A investors generally enjoy a higher return than Class B investors do. On the other hand, Class A investors do not enjoy a profit split. They do not see a return greater than the agreed-upon amount through the sale of the property or if the property becomes more profitable. They share taxation benefits with Class B investors.
Notably, a Class A investor in an apartment syndication deal generally has a higher minimum investment than a Class B investor. Because Class B investors yield a lower monthly return and make a smaller investment, they sit behind Class A investors. However, both types of investors sit ahead of the general partners. Notably, this means that Class A investors get their chunk of the return first.
For those offering apartment syndication investment opportunities, the appropriate rate to offer these investors will be below the total return on the investment. Generally, they receive between 7% and 10%, and Class A investors receive the higher return. It is important to adjust these figures according to the property’s return so that the entity can afford to pay all investors as agreed. Notably, the general partners may have a different percentage split, so using multiple investment tiers can get complicated. This may be particularly true if you have numerous investors participating in the apartment syndication.
It is important to note that investors do not always receive their agreed-upon return in regular intervals. For example, there may be a year when the property can only pay a 5% return one year rather than a 7% return. That difference will carry forward and will be due through future operations or at a capital event, such as the sale of the property. Because Class A investors receive their cut first, it is more likely for Class A investors to receive their full return on a regular basis. However, in exchange for the possibility of not receiving a full return regularly, Class B investors get a profit split at capital events on top of their agreed-upon regular rate of return.
Given the unique structures of these investment opportunities, Class A investors receive a guaranteed, capped return on their investment. Class B investors may receive a lower regular investment with higher upside potential through capital investments. This means that Class A investors are usually those who are interested in generating regular cash flow from their real estate investments. Class B investors are usually accredited investors who are looking for a higher overall return without the need for regular cash flow. Because there may be a different minimum investment amount for Class A and Class B investors, the tiered structure could be more appealing to those who want to invest a smaller amount of money.
Some investors, however, may want to enjoy the benefits of both investment tiers. If this is the case, they may be able to make an investment in both classes. This gives them the ability to enjoy gains from ongoing profits and from capital upside. Notably, the fact that both options are available to investors through a tiered structure may attract more interest overall. At the same time, your multifamily syndication project is open to a larger pool of potential investors. This may make it easier to pull together all of the capital needed to move a deal forward.
Both tier classes have their strengths and drawbacks. A tiered investment structure enables investors to optimize the benefits that they are most interested in. Because each multifamily syndication project is unique, it is important for real estate investors to carefully analyze the numbers before determining the most advantageous investor split for their next deal. To learn more about syndications from Joe Fairless and Theo Hicks, check out the Best Ever Apartment Syndication Book and listen to additional lessons through Syndication School today.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.