Equity Investment Structures Explained
The equity investments presented by Realty Mogul are generally structured through “direct participation” investment vehicles like limited partnerships or limited liability companies. These structures not only give you the benefits of passive investing, they also allow for the “pass-through” of depreciation, interest expense, and other deductions that that can reduce your taxable income. They represent a great investment alternative for investors who aren’t in a position to spend all their time searching for, and then managing, appropriate investment properties.
Investors will usually invest alongside a professional real estate company -- often called a “sponsor” or “operator” -- that will find a viable project and perform the related management chores once the property has been acquired. Such companies typically need other investors to provide some (or most) of the capital required for any single opportunity -- and these investors will then share in some of the project’s benefits (and risks).
Although limited partnerships are sometimes used, most real estate investments are structured using limited liability companies. These entities not only provide limited liability to the investing members (and usually the sponsor), they also allow for the “pass-through” of tax deductions that derive from the ownership of real estate.
The structuring issues then come down to how to divide the financial benefits of the project among the investing members and the sponsor. (Investors also want to know that a sponsor contributes at least 5-10% of the equity capital for the project, so that it has sufficient “skin in the game” that its interests are aligned with the investors.) For investors, a partial risk/benefit analysis might include the following:
|Property type/class, operational concerns, market conditions||Syndicator can bring expertise that investors can leverage|
|Sponsor may not devote sufficient efforts to a faltering project||Operators with enough “skin in the game” will work hard toward success|
|Syndicator may be motivated to move on and thus sell the property too cheaply||Sponsors with a significant share in the upside will try to maximize a sale price|
|Operator’s interests may not otherwise be fully aligned with those of investors||Structured with proper incentives, project can represent an attractive opportunity|
The negotiations involved in resolving these issues vary with each transaction, depending on the anticipated risks and benefits involved in the particular project. Over time, however, some common patterns have emerged for many transactions:
- Provide the vast majority of the capital (usually 80-95%)
- Receive a “preferred return” on their investment (often 5-10%)
- Receive a share of the remaining cash flow and profits (typically 50-80%)
- Receive the bulk of the tax benefits, such as depreciation and interest deductions
- Provides a small portion of the capital (usually 5-20%)
- Receives the same preferred return as investors on its own invested capital
- Receives a “promote” share of the remaining cash flow and profits
- May receive fees relating to property acquisition, loan financing, and management
- Receives some share of the tax benefits
Investors putting cash into a project also generally receive some “preference” in the return of that money before any “sweat equity” gets compensated. The preferred return, often in the 6-10% range, means that the investors will receive that amount before the sponsor gets paid any “promote” share of distributable cash flow. The preferred return is not a guaranteed dividend, however; sometimes the preferred return is not paid out because the property cash flows don’t allow it (for example, where the property is still under development). In such cases, the preferred return typically continues to accrue, and any unpaid amounts are ultimately recouped by the investor when the property is sold.
Real estate investment opportunities can be structured in many different ways; for example, pools of real estate properties can be owned through real estate investment trusts (REITs). The use of pass-through entities (like LLCs), however, can make real estate investing much more attractive; those structures allow passive investors to take advantage of many of the tax advantages of real estate ownership in a way that REITs do not. We’ll discuss these advantages in a subsequent article.