How are Passive Investors Paid?

by | Jul 26, 2022

After the excitement has set in once you’ve discovered the amazing returns passive investing through syndication can provide, you’ll want to dig in and get a better understanding of how you will get paid.  In this brief article, we’ll discuss the Preferred Return and the infamous Waterfall which accounts for the two main areas where you can expect to receive returns in this space.

Preferred Return

Most operators will provide a Preferred Return to their investors.  This means that the investor will receive a certain return on their investment before the operator receives any of the profits from the business operations.  This will generally fall in the 7-8% range.  So, what does this mean exactly?  Let’s say that you invested $100,000 in a deal with a 7% Preferred Return.  In this scenario, you would receive $7,000/year (usually monthly or quarterly distributions) before the operator gets any share of the profits.

It’s important to note that a Preferred Return is not a guaranteed return so you won’t necessarily earn the Preferred Return in the first or subsequent years.  You can expect to see first year returns in the value-add space around 3.5-6% for the first year.

Waterfalls

Once the operators have started to complete the business plan, the profits of the investment will start to improve resulting in returns that exceed the Preferred Return.  In most cases, the passive investor will receive additional payments from a waterfall structure.  Some common waterfall structures are 80/20 or 70/30 where the larger of the two numbers is usually paid to the passive investors.

Let’s use the same example we used earlier with a $100,000 investment with a 7% Preferred Return, and let’s consider a 70/30 waterfall.  Let’s also assume that there is a total of 10, $100,000 passive investors.  If the overall profit from the business operations is $1,000,000, the passive investors would receive a total of $70,000 (7% Preferred Return on $100,000), and then the remaining $930,000 would be split into $651,000 (70%) for the passive investors and $279,000 (30%) for the operators.  Each passive investor would receive $65,100 from the waterfall for a total of $72,100 ($65,100 for the waterfall + $7,000 for the Preferred Return).

Spend the time to understand the structure of the specific deal you are looking at and be sure to ask as many questions as you like to make sure you are comfortable with everything.  An educated investor is a confident investor which makes you a great partner for the many amazing operators in this space.

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