The Premium the Deal Sponsor receives for managing the project on behalf of the investors. It is compensation for the work, stress and time involved in managing the project
In this article I will present the two most common ways I see it done, there are probably tons of other structures out there but again, these are the two I see the most.
Before we get started, a quick disclaimer
I am not an Attorney or a CPA, this class is simply based upon my real world experience having done multiple syndications over many years. Some things discussed in this presentation may be different for you based on your specific situation, the state you choose to syndicate in and the current laws and regulations.
Please consult your own legal counsel and CPA for your individual situation
The two most common Promote Structures I see
While these aren’t exactly official terms they are how I refer to them. You have the straight and much simpler “Override” and what I will refer to as a “Reallocation” .
You buy a $10,000,000 property with an $8,000,000 loan and a $2,000,000 down payment.
In both scenarios the Sponsor will have an 80/20 promote split and has contributed 10% of the equity for the deal and is not subordinate
(refer to my article here for an understanding of the Subordinated structure)
When you do an Override you are taking your promote off the top of the distribution equal to your promote percentage. In this case, 20% on all distributions any time cash is distributed, be it from cash flow, refinance, or sale proceeds.
So in this 20% promote example, on a $100,000 distribution you, as the Sponsor, would take $20,000 off the top and the remaining $80,000 would go to the Limited Partners (LPs) on a prorata basis according to their ownership percentage of the deal.
If the total cash raise was $2,000,000 and the investor contributes $200,000, they would own 10% of the deal in the Override scenario
Sponsors often put some of their own funds into the deal so they would get a piece of the LP share in addition to their Promote.
Now, on the Reallocation you have a different structure all together. While the split on the distributions are roughly the same, there are others aspects of the deal that are very different.
The way a reallocation works (at least the way I do it) is that at the time of the closing of the offering and the property itself, there is a reallocation of the equity in the deal whereby the promote (20% in this example) is turned into straight equity in the deal for.
Let’s use our same example property, a $10,000,000 property with an $8,000,000 loan and a $2,000,000 down payment. Simplistically speaking, as there are other things involved to determine the equity in the deal, the equity in this deal would be the 2mm down payment because the basic formula is:
Asset Value – Liability = Equity
(Property) (Loan) (Down Payment)
In this reallocation scenario the Sponsor would have 20% of that equity due to their promote. So now any time a distribution is made the Sponsor receives 20% and the investors receive the balance 80%
Using the previous example of a $100,000 distribution the Sponsor would receive 20k just like in the Override situation and the Investors would receive the remaining $80,000 on a prorata basis according to their ownership percentage of the deal.
The difference this time is that the Sponsor, because of the reallocation, is in essence only selling 80% of the deal to the Limited Partners. If, like before, the total cash raise to do the deal is $2,000,000 and an investor contributes $200,000 then they would be purchasing 10% of the 80% of the company that the Sponsor is offering for sale (Think Shark Tank) and would own 8% of the deal.
Two rather large benefits to the Reallocation approach and one Caveat
One of the biggest differences and benefits for the Sponsor in the Reallocation approach is the treatment of the depreciation. Since the Sponsor now owns 20% of the equity from the promote and an additional 10% based on their personally contributed capital they will receive 30% of the depreciation benefit come tax time. The depreciation benefit is tied to ownership percentage in the deal.
In the Override case they would only receive 10% of the depreciation benefit based on their 10% personal cash contribution. The override didn’t come with any equity; it was simply applied to the distributions themselves.
Personal Net Worth
Another way the Sponsor benefits in the case of a Reallocation is the effect it has on their personal balance sheet (networth). Since the reallocation resulted in an additional 20% equity ownership of the company, their net worth would have increased by $600,000 because they now own 30% of a deal that has $2,000,000 in equity the day they close on the property. The Sponsor that takes the Override route will gain 10% of the equity or $200,000.
One thing to be aware of is the fact that, in the case of the Reallocation, the equity you receive as your promote is considered compensation if you don’t pay for that equity. If this is the situation then you may be rudely reminded by the IRS that you now owe taxes based on that 20% equity you received from the promote. In this case that 20% equity had a value of $400,000 and if you have an effective tax rate of 20% you now have to write a check to the IRS for $80,000, OUCH!! The way around this is to buy the equity for a nominal amount so you establish a basis in that equity, this approach is much more palatable for taxes.
(PLEASE CONSULT WITH YOUR CPA OR TAX PROFESSIONAL)
There is a slight difference in the effect of using a reallocation rather than the simpler override approach on cash distributions but significant differences for the Sponsor themselves. As always, if you decide to employ my version of a reallocation you just need to make sure you are still able to deliver projected returns in line with what your investor base requires in order for them to invest. Also, as the Deal Sponsor, it is your responsibility to be able to clearly and effectively explain your structure and the resulting projected return to them as an investor.
Understand, there is no right or wrong way to do this, just personal preference. You do, however, need to ensure you understand the process and all of the effects that it will have on you, your deal, and your investors.
WANT YOUR COPY OF MY BOOK ?
Known in the real estate world as the Apt-Guy℠, Bruce Petersen is a serial syndicator who started with a 48-unit building and has now syndicated over 1,100 units. As the founder and CEO of Bluebonnet Asset Manager LLC and Bluebonnet Commercial Management, Bruce is a #1 Best Selling Author and has received local and national recognition for his syndication efforts. He was the recipient of the Austin Apartment Association’s Independent Rental Owner of the Year for 2016 and the National Apartment Association’s Independent Rental Owner of the Year for 2017. In addition to being a TV personality and public speaker, Bruce also mentors people on how to invest in apartment complexes.