Real Estate Syndications 101: How Investors and Operators Actually Get Paid | Michael Russell E54

Ever wonder where the money actually goes in a hotel deal?
In this episode, Michael Russell breaks down real estate syndications in plain English. How investors and operators really get paid, what fees are fair, and how to structure deals that build long-term trust.
Whether you’re looking to raise capital for your first project or invest passively, this is the playbook for understanding the math behind every syndication.
You’ll learn:

• The simple breakdown between LPs and GPs and how each gets paid
• How preferred returns, profit splits, and waterfalls actually work
• The most overlooked risk in syndications (and how to avoid it)
• How to structure deals that attract repeat investors
• Why clarity always beats complexity when raising capital

If you’ve ever wanted to peek behind the curtain of a hotel syndication, this episode will make everything finally click. Follow and share the Hotel Investor Playbook so more people can learn how to invest in hospitality assets the right way.

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Transcript

Michael Russell 0:03

Welcome to the Hotel Investor Playbook, your guide to building wealth and freedom through boutique hotel ownership, hosted by Mike and Nate. Get in the game. Welcome to the Hotel Investor Playbook. I'm Michael Russell, co-founder of Malama Capital, and your host. On this podcast, we talk story about everything you need to know to make money investing in hotels and in hospitality assets. Now, today's episode is a little different. There's no guest. I'm not interviewing anyone. It's just me talking directly at you. And the reason I want to do this is because I've had a lot of people. They reach out, they want to know how a real estate syndication actually works behind the scenes. How do returns get split? What's a waterfall? What does the GP actually earn for all of their work that they put into raising money and putting the deal together and everything? So I figured let's break this down. I'll walk you through how we structure our deals, what terms matter, and the different ways that capital gets distributed in a real estate investment. So whether you're thinking of raising money or you're investing passively, this is the episode I wish I had when I was first getting started. So let's dive in. Now I want to start with really just defining what is a syndication. In simple plain English, it's basically when multiple investors pull their money together to buy a bigger asset than they could on their own. And there are two roles, essentially. There's the limited partner. These are the folks that bring the money. So they're passive investors that put up oftentimes most of the money. The GP is the general partner. This is the person or group of people that are active operators, otherwise known as the sponsor. They run the deal, they find the deal, they set up the financing, they set up the management, they ultimately are responsible for everything A to Z from purchasing to ultimately selling it. And naturally, they should get compensated. So we're gonna walk through the specifics of this, but I want to give you some context and some background here before we get into all the nuances of the syndication. So from a concept here, why are syndications a popular method for purchasing real estate? I mean, this happens all the time when you walk down any major city block and stare up at the sky, and let's say you see one of those huge buildings, in all likelihood, that building was purchased by a syndication. Now, not every time, but syndications are so common in hotels and just in general in commercial real estate, because it gives people the ability to step up into larger assets that they otherwise wouldn't be able to afford to purchase on their own. So if you've had success in Airbnbs and you know you're able to purchase, let's say, a$1 million Airbnb, well, how feasible is it to go purchase a$10 million hotel? Obviously, not everyone has the capability to do that. So syndications open up the opportunity for more people to own larger assets. Now, another advantage of syndications is that you've got skilled operators, they have this talent, they have this experience, they have all this concentrated knowledge on how to effectively purchase and operate real estate, but they don't necessarily have endless amounts of capital. So it's a combination of matching capital where people want to deploy it and invest with experts that can go out and effectively purchase the real estate, run it, and ultimately sell it at a profit. So it's a win-win. So those two roles, limited partner and general partner, we're gonna really dive into how each one gets paid and the amounts respectively that they earn in general. But I also want to add one additional point here. There's a lot of opportunity for people with capital to deploy it. You know, you can invest in the stock market. Folks that have 401ks, they might put it into the S P 500 index and just kind of set and forget it. But what real estate provides obviously is diversification. The challenge, though, is most people, when they think about investing in real estate, they associate with the risk of, well, I don't know how to do that myself. I don't know how to find these deals. And the beauty of a syndication is when you get an expert operator, they're able to gain access to deals that are not publicly available. When everyone has access to the same stocks, the same bonds, the same index fund, the returns are often mediocre because everyone has access to them. But real estate is unique in that it is an inefficient market. Not everyone has access to the same information. If you can go and align with an expert who can unearth gold and give others the opportunity to invest and share in that potential asymmetric return, that huge upside. Okay, so now that we have a general understanding of what the key definitions are and the key roles, let's get in directly on how do GPs, general partners, get paid. There's a number of ways. GPs typically earn fees and share a percentage of the profits, but the fees, typically an acquisition fee, which can be two to four percent of the project cost. These are not absolute, these are just ranges, rule of thumb. There's the asset management fees. So GP is responsible for managing everything related to the ongoing operations. I'm not talking about at a property level management. I'm talking about managing the manager, making sure that cash flow distributions are paid out, making sure that insurance is in place correctly. I'm talking about refinancing and then ultimately selling it. So there's a lot of ongoing responsibility. Disposition fees, obviously, when the property sells, this is variable. So rule of thumb, maybe one to two percent of this sales price goes to the GP. And the management fee, by the way, is sometimes a GP will also manage the property. So the term vertically integrated means that the GP is basically managing it as well. And there's a separate management fee for hotels, a management fee, depending on the asset size, it can be anywhere from two to eight percent. That's a broad range, but the larger the amount of revenue, the lower the percentage. So let's just say for example purposes, if your hotel is bringing in around$2 million in revenue, you might see a property management fee between five to maybe 7%, maybe 8%. Again, that's all negotiable and it depends on a lot of factors. All right, so now that we've covered the fees, let's talk about proceeds from a syndication and how those are split up between the LP and the GP. So this is commonly referred to as a waterfall structure. Proceeds typically are paid through like regular proceeds from cash flow, or it can happen from a capital event. So cash flow being ongoing cash flow from operations, and these can often be paid monthly or quarterly, quarterly probably being more common. But the capital event, the other way, is either through a refinance or sale. So I'm gonna use a very basic waterfall structure for a demonstration on how proceeds from either of these two main events can get split up. So the most common and a simple, simple waterfall. Number one, it's important. LPs, limited partners, the first proceeds typically the LPs get 100% of their capital returned. That's like that's number one, they at least got to get their money back, right? And then number two, oftentimes the syndication is structured where the LPs will get a preferred return, also known as a PRF. And typically a PREF can be anywhere from seven to 10%. And what this means is the very first seven to 10%, that goes all to the limited partner. So that's kind of like, hey, here's your basic minimum. Whatever this asset is producing, this syndication is producing, the first seven to 10%, whatever that is agreed to be, goes to the limited partners. And then thereafter, there can be a profit split. So oftentimes the profit split between an LP and a GP will be, let's call it 70-30. That's just an example. It can be 6040, it can be 80-20. But the point is the majority of the proceeds of the profits go to the limited partner. So pretty good deal. Now you can structure this anywhere. This is just an example. This these are this is the common way that people set this up, but there's a million ways you can set up a waterfall. I'm just trying to keep this simple. So I'll give you a quick example using some numbers on how this might actually play out. All right, so let's say that a syndication raises a million dollars from private investors. So the total LP equity is a million dollars. And in year one, there's no cash flow, which is often common because initially you're stabilizing the property. There might be some one-time expenses. So we're gonna go in this example and say that year one, there's no cash flow. So there is no PRF. We're gonna use, let's say, an 8% PREF, but there's nothing to be distributed because there was no cash flow. Maybe the syndication is using some of the reserves that may have been raised ahead of time to cover negative cash flow initially. Just an example. Year two, let's just say cash flow from operations is a hundred thousand dollars. So if the PrEF is eight percent, the first eight percent goes to the LP investors, which would be eighty thousand dollars. If you've got a million dollar investment, eight percent on that would be 80k. That goes to the LP. So that means the remaining$20,000 out of that$100K of cash flow from operations, that gets split$0.00, for example.$70 to the LPs,$30 to the GPs. That means the LP gets$14,000 and the GP gets six thousand dollars. Okay. Year three, let's say cash flow from operations is double, eight percent on the one million dollars that was originally invested, again, eighty thousand dollars right off the top goes to the LPs, and the remaining cash flow is split 70-30. So if there's 120 grand left over after$80,000 is paid as PREF,$200,000 minus$80, there's$120,000 left over. That means$70,$30 split,$84,000 goes to the LP,$36,000 goes to the GP. Ah, this goes on each and every year until there is an event. An event being either a refi or a sale. So I want to give the example of a refi. Let's say in year three, the ASA is performing well enough to qualify for a cash-out refi. Well, pro proceeds from the refi, of course, after the 8% PREF is paid, count towards that 70-30 split. So let's say, for example, there's$500,000 to be paid to the LP investors after accounting for the PREF and the LPGP split. It's important to explain that$500,000 from an event oftentimes will be considered a return of capital, not a return on capital. So every waterfall is structured, structured differently. The way that we do so is at an event, the return of capital is made. Now, this is super important because moving forward, that 8% prep, that preferred return, that's only paid on the remaining capital that's still outstanding. So if the investors have received$500,000, which is half of the original$1 million, moving forward thereafter, that preferred return is only 8% of$500,000 thereafter instead of 8% of$1 million, which means their preferred return on an annual basis is no longer$80K, it's now$40K. And this is very important from a GP's perspective because the sooner you have an event in which you give investors portion or perhaps all of their original capital back, the sooner you start moving towards that 70-30 equity split without having to pay as much preferred return to the GP. Just know it's in the GP's best interest to return capital to the investors as soon as possible, because then the PREF may no longer apply thereafter, once investors received all of their initial capital. Now the split still continues. And if you set it up with a 70-30, then you know this will carry on until you sell the asset. And at exit, 70% in this example goes to the LP, 30 to the GP. Now, there are more advanced waterfall structures. You can have it tiered, for example, you might change the equity split based on targeted IRRs. So for example, I've seen people where they'll structure that an investor that gets so up to 10% IRR might be a 70-30 split. If they reach 10 to 15% IRR, maybe the equity split then is 60-40. Now, what we have done in our in some of our deals, the way we structure these is when we're we're lining up a deal, we might actually target a threshold of a 15% IRR to the investors at a 70-30 split. And thereafter, any returns that are higher than 15% IRR are split 50-50. Now, there's pros and cons of structuring more complicated waterfalls, but oftentimes it's best to just keep it simple. This is just an example to get familiar with how our waterfall may work. Another component to be mindful of is to understand whether the preferred return gets paid on a simple or compounding basis. Now, this is super important and this is a detail that often gets overlooked. But if you are considering being an LP and you don't know what I'm talking about, then pay attention to this because you need to know the difference. In a syndication, it is possible that during the first few years, you might be light in profits, and it's possible that a PREF might not be met. So, in a simple interest scenario, the amount missing from let's say that 8% on original capital, if that goes unpaid, then that's it. However, if the PRF is based on compound interest and that pref is not paid, then that 8% carries over to the next year and is compounded on the amount that went unpaid. So something to be aware of. Another concept that can be beneficial if you want to throw this in your waterfall is the catch up. This is for a GP. So if a GP implements a catch up, then retroactively the catch up provides the ability for them to catch up to the agreed promote after the LP gets their PRF. So an LP might get their PRF one year and the GP doesn't get anything. Well, the next year, if there's additional profits to be split above the PRF, then that would go first to the GP to catch up. Okay, now I want to shift gears into how a GP structure can often be organized in terms of what individuals within a GP might be able to earn for their respective roles. So their GP can be split up in a variety of ways. I'm gonna give you an example, but let's assume that in this general partnership that there's more than one person, there's multiple people involved. And there's a lot of different ways to do so. I'm gonna give you examples here, but let's say you split it up into roles of there's capital raising, there's deal sourcing, there's construction management, there's asset management on an ongoing basis. And then you have to, there's some people that will be able to personally guarantee a loan, and then those that may not have the credit or ability to really add value in that regard. So depending on how you set this up, I feel like it's really important to split up each role by the percentage of participation. So for example, let's say there's four people that can sign the personal guarantee. Well, you might assign that 10% of the GP is paid for those that sign the personal guarantee. So if there's four people, that means each person that signs would get two and a half percent of the GP. Here's another example. Really common. It's very common for capital raisers to get a percentage of the GP, let's say 30% of the GP. Well, rather than just assign 30% flat, compensation for capital raising should be based on performance for each individual involved. So if someone goes out, let's say they raise half the capital, they would earn half of the allocation, let's say 30%, they would earn half of that 30% that is allocated within the GP. So in this case, half of 30% would be 15% of the GP for capital raising. Now they can still be involved in the other aspects, construction management, let's say, or asset management, but whatever category, it's really important to divvy up the GP internally based on contribution and risk. GP's got to be earned, can't just be flat. So something to keep in mind, everyone structures their GP differently. This is just how we like to do it. Okay, I'm gonna move on now to some of the tools and admin software. I want to show you how to manage the admin side a little bit. Now, obviously, everything can be done in Excel from an underwriting model perspective. If you don't have an underwriting model, there's a variety of ways that you can retrieve one. Now, most commonly, people have paid thousands of dollars for a custom one to be built, let's say by a skilled developer that you can find on something like Upwork. But I think it's worth noting that in the last several months, there's been a multitude of AI programs that can build your model. Oftentimes they can do a really outstanding job. You could always purchase a pre formatted templated model online. Here's some AI companies that are doing a really Really nice job in helping with developing underwriting models. So, for example, index or shortcut, or you could even try Perplexity Labs. I've used all three of these, and I think that this is an efficient way to build out a model without having to spend thousands of dollars. I don't have any tie to any of these companies that I'm recommending, but these are just what we're using. And so I thought I'd just share this info. Now let's talk about the investor portal. So, an investor portal, you need some central hub to where you're gonna track all of the money that has come in from investors. You need some sort of dashboard that you know you can keep track of everything. You need to and facilitate, you need to facilitate investor communications, you need to send out the waterfall payments. So there's a ton of software providers out there. We're using cash flow portal. We found that that works very well, but there's a lot, there's like Juniper Square. I mean, a quick Google search, and you're gonna find that there's a lot of options. So pick the one that you like best. Oh, and on that subject, look, these portals are really important. You need to be able to expedite the verification of investor accreditation accreditation. These portals have the ability as add-ons to expedite that process and all the investor onboarding and the documentation and the private placement memorandum, all of these things, these investor portals are pretty sophisticated. They can reconcile distributions. Oh, one thing I think that is important is if you're listening to this and you're going, oh my gosh, like all of this tracking of these things and making sure, go and hire a remote bookkeeper. Or, you know, you can use one obviously in the mainland, but there are really quality remote bookkeepers these days that are they're skilled. Ours are in the Philippines, and honestly, they are outstanding. I fired like four or five bookkeepers here in the mainland, and I finally found one overseas, and it's incredible the communication and the skill sets, and for the price, I'm getting a way better value. A little food for thought. So where are we here? I would say we've kind of covered a lot. If you're thinking about structuring your first deal, here's some advice. Just keep it simple. I would not recommend a complicated waterfall. Keep may you know, use the let's just say the 8% pref, the 70-30 split, but do charge fees. I feel like I've looked at enough deals of people bringing our way and they're not collecting enough in fees. Either they're skipping the asset management fee altogether, or they're not collecting enough in an acquisition fee. Like, look, I started this episode by saying how important it is to unearth gold. A GP's value needs to be compensated appropriately. If you're not charging an appropriate acquisition fee, then you need to find a deal that works where you get compensated. You need to figure out a way, either the deal has to be larger or the returns need to be better, but you're not working for free. And if you are, you're gonna burn out. This is a game that you you know, if you're bringing value to the table, make sure you've got you've got an acquisition fee baked into your structuring your deal. And same thing goes with the asset management fee. Look, it there's a lot of ongoing work here, and you got to keep the lights on. So make sure that those fees are incorporated, but make it fair, don't be overly greedy. Obviously, everything is about moderation. So build relationships, not just deals. Hopefully, this episode helped demystify how waterfalls work and this gives you a little bit of insight into how the deals are structured and the key terms and what to look for. So if you found this episode helpful, please share it with someone. And if you're an LP or limited partner investor looking to get involved in one of our hotel deals, we'd love to connect. You can find me on LinkedIn, just search Michael Russell and Hotel Investor Playbook, or head over to MalamaCapital.com and check out what we're up to. Thanks as always for listening. Talk soon. Aloha.