There can be a significant difference in the return for the limited partner or passive investor not to mention how it works for the Sponsor themselves.
What Does Being Subordinate Actually Mean?
When the Sponsor is subordinate on a deal, usually refers to sales of the property, he or she doesn’t get paid their Promote or premium for managing the deal until the investors have received their original investment back in full (to understand how the original investment is tracked you can read my article of Return Of and Return On Investments https://www.linkedin.com/pulse/return-investments-bruce-petersen/).
Once the Investors have received the balance of their original investment back then and only then does the Sponsor receive their Promote on the excess profit from the capital event.
How the Deal Structure Can Affect Your Returns
The Deal
50 units
Purchase Price: $5,000,000
Loan (interest only): $4,000,000
Down Payment: $1,000,000
Closing, Operating Capital, Rehab: $500,000
Total investment to purchase: $1,500,000 (investor capital)
Total Cash Flow Distributions: $750,00 (5 years)
Sales price: $7,000,000
Gross Profit from Sale: $3,000,000 (sales price – loan)
Subordinate Example
The property sells at the end of year five. During this hold period the investors have received a total of $750,000 in cash flow distributions. Being subordinate, the Sponsor has to first return the balance of their invested capital or $750,000 before they can take their promote.
So, the profit from the sale was $3,000,000 of which they had to take the first 750k and return it to the investors and then split the remaining profit where the investors received $1,800,000 in profit and the sponsor received $450,000.
Total cash received by the investor from the deal was:
$750,000 in cash flow distributions,
$750,000 from the return of the remaining capital account balance
$1,800,000 in sales profits
$3,300,000 total dollars received during the investment
This represents a 220% return or a 120% profit
Non-Subordinate Example
Same story, property sells at year five. Cash flow distributions in the amount of $750,000. This time the sponsor is not subordinate so they do not return the balance of their originally invested capital.
The profit from the sale is still $3,000,000 but this time the entire amount is subject to the Sponsor’s promote of 20%. Investors receive $2,400,000 and the sponsor receives $600,000
Total cash received by the investor from the deal was:
$750,000 in cash flow distributions,
$0 from the return of the remaining capital account balance
$2,400,000 in sales profits
$3,150,000 total dollars received during the investment
This represents a 210% return or a 110% profit
Conclusion
This is a rather simplified look at the effects of being subordinate in a deal as a limited partner or passive investor. The difference in the two approaches was not a large one in this example. The main thing is to understand the difference, how the sponsor is structuring the deal and what the end result is projected to be for the investor.
There is no “right” or “wrong” way to do this, simply different approaches. Part of being a sophisticated investor means you should understand what they’re doing.
Bottom line should be whether or not the projected return for you as the limited partner/passive investor, regardless of their deal structure, fits within your investing expectations and model.
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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.
