Multifamily Syndication Splits: Is Higher or Lower Better?
Are lower splits better when it comes to multi-family syndications?
This was a question that came up the other week during one of my Facebook live streams. I thought it was a really good one.
In this blog post, I’m going to walk you through how splits work when it comes to syndications and investing and how they impact your returns and your overall investment.
What Are Splits?
Splits are basically how the proceeds of a deal are paid out between both parties in the syndication. On the one hand, we have LPs (limited partners) — passive investors. On the other hand, we have the GPs (general partnership) — the people actively running the deal.
The 2 Ways LPs Make Money in a Syndication
A. Cash Flow
Every month or quarter — depending on how the syndication is set up — we have free cash flow. After the expenses are paid — after the debt is paid, after reserves are met (so we always keep money apart for a rainy day) and then if we have any cap hacks (so if we’re doing any renovations, if any of that money is being used for that, that is also allocated) — we have profit. We have free cash flow.
So how is that going to be paid out to both parties? Well, that is a split. Splits can range from 80/20 in favor of the limited partners. We can do 60/40, we can do 70/30, and everywhere in between. The range varies, and it really depends on the deal.
B. Sale (Divestiture)
The same thing happens when we sell the property. We’ve forced the appreciation of the asset using the value-add strategy. And now it’s time to sell and receive our profits. Once again, splits dictate how much of the profits get shared to the LPs and how much gets shared to the GP. So splits are really saying, “Okay while we’re investing in this deal, from all the profit we make, this is how the money is going to be allocated.”
As passive investors in a deal, we all want to make the most money. We want to have our money earning the highest return possible. That’s why we’re investing. This is why we are putting our money into a deal.
What Makes a Good Split?
Obviously, everybody likes a deal. We’re all on the hunt for a bargain. So it may be tempting to say, “Oh well this one deal is offering a very, very low split in favor of the general partner. Maybe they’re only doing 80/20, or 90/10, let’s say, or something like that. But you know, my money’s going to be working harder in this deal.”
Well, I want to caution you. This is why I wanted to do this blog post. I thought the question during the Facebook live stream was really good.
(I do these live streams once a week on Facebook. Check out the link in the description for a free Facebook group — a bunch of great people in there. Everybody is learning and encouraging each other as they invest in multi-family real estate deals.)
As I said, it can be tempting to say, “Okay, this one split is really low. My money’s going to be working harder.” But is that really the case? I would argue no. And I want to walk you through a couple of scenarios or ways of thinking about it that may shift your thinking and put you on a more strong path for your investing.
Scenario 1: Lower Split, Higher Fees
The first thing to consider is if we have a very low split. Is this really a marketing tactic? We have a really low split, but then, maybe we have much higher fees, right? Because what happens is we have to split — this is how everything’s distributed. But we also have fees that are charged by the general partnership — acquisition fee, construction management fee, and perhaps a refinance fee. There are many different ways that fees can be worked into a syndication, depending on the specific deal.
So maybe the fees are higher if they’re advertising a lower split. Maybe that’s how they’re trying to enter the market or advertise their deal. You know, “we have really low splits, come invest with us!” But then they’re charging a lot higher fees to make up for that amount.
Well, here’s the thing that you should consider in this case: Fees are paid no matter what. But splits are paid based on performance. So as a passive investor, you actually want the general partnership — the people running the deal — to be rewarded for their efforts if they perform well. But with an asset management fee or something like that, that is being paid no matter what happens. If nothing’s getting paid, even if there are no profits, the asset management fee is still going to be paid.
Is this really the best setup or scenario for you as a passive investor? I would argue no. You actually want the general partnership — the person managing your money and making the decisions about the deal — to be incentivized by making money when the deal is going well.
If we have too low of a split, the GP doesn’t have a big enough piece of the pie. So where is their incentive to actually perform on the deal? This is the second thing I want to talk about.
Scenario 2: Higher Split, Lower Fees
Let’s say the market gets choppy and the deal needs a lot of attention. And suppose the general partnership owns eight properties that they’re currently running. Maybe on a month of deals, for whatever reason, they offered a lower split.
We are all human — whether passive investors or general partners. Let’s say things get really really tough. And they have to work hard on a deal. As a human being, would you put more effort into a deal that’s going to give you a bigger paycheck and reward you for your time? Or would you put your time and effort into a deal that’s going to pay you peanuts because the split structure was wrong?
I’m not saying most people would do that, but the incentive has to be there. The carrot has to be there. If there’s not a big enough piece of the pie to make it worthwhile for the general partner, how are they incentivized to put 110 percent into the deal, squeeze out every dollar, and really put your money to work?
It’s like on Shark Tank. I enjoy watching Shark Tank and we actually have Kevin O’Leary speaking at the Multifamily Conference in May 2022. So I’m really excited about that. (We’ll put a link down there so you can buy your tickets if you’re interested. It’s going to be an amazing event.) But on Shark Tank, you’ll hear lots of the sharks talking. They’ll say, “I don’t get out of bed for five percent.” “I don’t get out of bed for 10 percent.”
Well, the same thing happens with multi-family. You need the general partnership to be invested in the progress and the results of the deal. This is why you actually want them to have a split, so they’re incentivized. If the deal’s going well, you as the limited partner are going to get rewarded. But the general partnership wants to get rewarded too. And that’s what’s going to force them and have that carrot dangling in front of them. It’s money, right?
So you want them to be incentivized. So if there’s a low split and high fees, the general partnership isn’t really incentivized to do well because they’re going to earn the fees no matter what. But if it’s a higher split and lower fees, now we’ve really shifted it to where the GP is going to be rewarded based on how well the deal goes, along with the limited partners.
Remember, you’ll hold these deals for five, seven, or ten years. Do you really want to be invested for that period of time with somebody who has no incentive to perform on the deal? That’s a very long period of time. There has to be that incentive — the light at the end of the tunnel, the carrot, the lucky charms in the pot of gold — however you want to picture it.
The Bottom Line
Once again, the incentive has to be there. This is extremely important, especially for new investors coming in with capital. Everybody loves getting a deal. But you have to really think: “Is my money in the best hands? Where are the alignments of interest? Is the general partnership, the person running the deal, really incentivized to make sure my money is working as hard as it can be?”
I would argue that having lower fees but a higher split would ensure that the general partner is going to potentially earn more money in the deal if it goes well. But I would also argue that the limited partnership is going to do better as well because the general partner is more incentivized to really give that 110 percent effort.
Do you agree or disagree? Leave me a comment. Let me know what you think. And if you are interested in learning more about investing in multi-family, join our free Facebook group, a great group of people. Come join us and say hi. We have live streams every week. And if you are an accredited investor and you’re interested in learning more about the deals I’m currently looking at, head on over to CallSeth.com and set up a free 20-minute phone call with me. And if you like this article and found it useful, leave a comment. Hit the like button. Let me know what you think. And until next time, happy investing!