By Joel Heck
One of the most important responsibilities for a sponsor in a syndication is protecting their investors’ capital. The business plan for a syndication may last 2, 5, or 10 years, but eventually the limited partners in the deal will want their money back. If you’re a limited partner in a deal, it’s important to understand how and when you’ll receive your initial capital back because it can impact your returns.
Each syndication structures returns a little differently, but I’ll give you a general idea of the different ways a limited partner can get their initial capital back.
It’s important to remember that in a syndication, your returns are proportional to the amount of capital you have invested in a deal. The more capital you have in a deal, the more money you’ll earn. While it’s great to get your initial capital back to spend or place in another investment, you need to be aware of how a reduction in capital invested in a deal affects your future returns.
Selling the property
Let’s first look at the simplest way to get your money back. When the sponsors sell a property, they first return their investors’ initial capital. Ideally, the property sells at a profit, so the investors receive all their initial capital plus a profit.
However, there’s always a risk that the deal doesn’t go as planned and the investors don’t get all their capital back. It’s critical to evaluate the sponsors and deals you invest in to reduce this downside risk.
Another capital event is a refinance. Usually when sponsors refinance the debt on a deal, they look to refinance a short-term loan into a long-term loan and pull out money from the deal because the property has appreciated. They can use this money to return some or all the initial capital their limited partners invested.
When reviewing a deal, check the legal documents or ask the sponsor for how a refinance affects the returns for the limited partners. Usually, the limited partners stay invested in the deal, even if they got all their capital back, but the total amount they get from a preferred return will drop. However, some sponsors may use a refinance to take their passive investors completely out of the deal.
Let’s look at an example. If you invested $50,000 with an 8% preferred return, you’d expect to get $4,000 each year. After a refinance you might get back $30,000 so you only have $20,000 left in the deal. Now the preferred return is 8% on the $20,000, or $1,600. The refinance shouldn’t affect the profit splits, so you’ll still get your split of the profits above the preferred return.
When investing in syndications, expect your capital to be tied up for a few years. Most sponsors plan on holding a property for 5-7 years, but the plan could change depending on the market conditions and how the property is performing. In a rising market, it may make sense to sell or refinance in 2 years, and in down markets sponsors may hold on longer than expected.
Return “of” capital vs return “on” capital
The other, potentially unexpected, way a limited partner may get their initial capital back is through distributions that are a return of capital instead of a return on capital. The distinction is important.
A return of capital means that the monthly or quarterly distributions a limited partner receives reduces the amount of capital they have invested in a deal. Going back to the example of an 8% preferred return with a $50,000 investment, the first monthly distribution would provide the investor with $333 and reduce their invested capital to $49,667. The following month the distribution would drop to $331 because the return is based on $49,667 instead of $50,000. Over the length of the investment, the investor would receive less money than if the distribution was a return on capital.
A return on capital does not decrease your equity, so if there is a preferred return, the limited partners’ distributions should remain the same if the cash flows support them.
As a limited partner, you should review the legal documents and talk with the deal sponsor to make sure you understand how the preferred returns are classified before investing.
Remember that real estate investments always carry risk, and it’s possible that the limited partners will not get some or all their capital back if the deal sponsor is untrustworthy or a deal performs poorly. However, it’s unlikely that the value of a real estate investment will go to zero since it’s backed by a physical asset. Even if the property burns down, the sponsors will have insurance to protect the invested capital.
To recap, limited partners can usually expect to get their capital back through a refinance and sale of the property within about 5 years, though it varies from deal to deal. They can also get their capital back through distributions that are a return of capital, though that is not ideal. Before investing in a deal, make sure to ask questions and review the legal documents so you understand how the sponsor plans to return your capital.