For passive real estate investors looking to partner with the right private equity company, it’s very important to clearly identify the business model being offered for two reasons: First, it defines how the Capital Partners (passive investors) and the Sponsor (private equity company) will be compensated for their respective pieces. Second, it underscores the alignment—or potential misalignment—of each party’s investment objectives. So, what are the generally accepted models, and which one is right for you?
There are two basic models: a Joint Venture (JV) and a Preferred Return (PR). Please note there are many nuances to each model and the devil is always in the details, but for the purposes of this article we will cover only basic concepts. Just a heads up that this article is a bit longer than usual and there will be some math involved. But the content is necessary to get a full understanding of each model. Besides, we are talking about your investment future so it’s no time to cut corners!
Joint Venture
A JV model typically offers an 80/20 equity split, meaning the Sponsor takes a 20% equity interest in exchange for services provided and the remaining 80% interest is given to the Capital Partners. In a JV, the Capital Partners and the Sponsor share a common position (also known as “pari-passu”) in the distribution of cash flow from operations and equity at sale according to their pro-rata ownership interests.
The beauty of this model lies in the simplicity of the structure and the inherent alignment of interests between the Sponsor and the Capital Partners. Simply put, when a Sponsor is making cash flow from Day One, alongside the Capital Partners, the Sponsor is financially aligned to hold quality, cash-flowing assets for the long term and only sell (or refinance) at the “right” time, not necessarily at the first opportunity to get “promoted.” (We’ll cover this concept later in the Preferred Return model.)
Example 1: Joint Venture cash flow split from operations
As a first step, let’s look at how the cash flow from operations gets split between the passive investors and the Sponsor in a JV model. From Table 1, let’s assume Property A generates $1.290M in property level or total cash flows over a 5-year hold. In a JV model with an 80/20 split, the Capital Partners would receive $1.032M ($1.290M x 80%) and the Sponsor would receive $258K ($1.290M x 20%). The key is that both parties receive their pro-rata share of distributions at the same time (pari-passu) with no priority given to one or the other.
Table 1
| Property A | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total |
| Total Cash Flow |
$150,000 | $210,000 | $270,000 | $300,000 | $360,000 | $1,290,000 |
| Sponsor Cash Flow |
$30,000 | $42,000 | $54,000 | $60,000 | $72,000 | $258,000 |
| Investor Cash Flow | $120,000 | $168,000 | $216,000 | $240,000 | $288,000 | $1,032,000 |
Now when it comes time to exit the property, the same distribution structure holds. Upon sale, after all outstanding debts are paid off and 100% of the investor capital is returned back to the Capital Partners, any remaining cash is distributed pari-passu with an 80/20 split.
Investment Tip: Always ask a Sponsor how your capital investment will be treated in the capital stack when it comes time to exit the property. You should confirm that a full return of capital will be prioritized after all outstanding debts are paid off and that the Sponsor will only participate in its pro-rata share of any remaining cash.
Example 2: Joint Venture equity split from sale
Let’s calculate how the equity at sale gets divided for the same property in a JV model. From Table 2, let’s assume Property A is purchased for $10M by the Sponsor. A first mortgage of $7M is secured and a capital investment of $3M is raised from the Capital Partners. To keep things simple, let’s ignore closing costs and assume an interest-only loan for the duration of the hold. In Year 5, the property is sold for $12M. Upon sale, the first priority is to pay off the debt ($7M) followed by a full return of investor capital ($3M). The remaining cash or equity ($2M) is split pro-rata. ($1.6M to the Capital Partners, and $400K to the Sponsor.)
Investment Tip: Ask the Sponsor if they will be investing their own capital alongside the Capital Partners. Known as the “co-investment”, this ensures that the Sponsor has sufficient skin in the game.
Table 2
| Property A | Year 1 Purchase |
Year 5 Sale |
Sponsor Equity | Investor Equity |
| Purchase / Sale | $10,000,000 | $12,000,000 | ||
| Loan | $7,000,000 | ($7,000,000) | ||
| Investor Capital | $3,000,000 | ($3,000,000) | ||
| Equity | $0 | $2,000,000 | $400,000 | $1,600,000 |
In Tables 1 and 2, we calculated how operational cash flow and equity at sale get split. For Table 3, we simply combine the two to get our total return. As you can see, in a JV model the property level total return is $3.290M, of which the Sponsor receives $658K and the Capital Partners $2.632M. This equates to a 1.88 Equity Multiple for the Capital Partners, which means if you had invested $100K in this property, you would have received your $100K back, plus $88K in combined cash flow and equity at sale over a 5-Year hold. That’s equivalent to a 17.6% average annual investor total return ($88K / $100K / 5 years).
Table 3
| Property A | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Exit Equity | Total Return |
| Total | $150,000 | $210,000 | $270,000 | $300,000 | $360,000 | $2,000,000 | $3,290,000 |
| Sponsor | $30,000 | $42,000 | $54,000 | $60,000 | $72,000 | $400,000 | $658,000 |
| Investor | $120,000 | $168,000 | $216,000 | $240,000 | $288,000 | $1,600,000 | $2,632,000 |
Preferred Return
In a Preferred Return (PR) model, the Capital Partners are given a preferred class of equity as opposed to a common position. In this structure, the Capital Partners receive the first distributions (before the Sponsor) until a minimum specified rate of return (also called an “investor pref”) is achieved. A typical PR model will offer an 8% cumulative investor pref against the invested capital. However, with rising asset pricing and lower yields, it’s not uncommon to see investor prefs in the 6% range these days. After the investor pref is achieved—often referred to as, “clearing the first hurdle,” or “waterfall”—any remaining cash flow is typically split on a 70/30 basis, with 70% to the Capital Partners and 30% to the Sponsor. More intricate pref models will have several more hurdles based on clearing additional return thresholds, but the basic idea remains the same.
While Preferred Returns are not guaranteed, passive investors like this model because it lessens the risk in achieving an acceptable return on their investment, and it incentivises the Sponsor to perform above the investor pref before it can receive any distributions itself. Also, investor prefs are typically “cumulative,” meaning they accrue year-over-year. For example, if there is not enough cash flow to pay the Capital Partners a full 8% in Year 1, any unpaid balance carries over into Year 2, same in Year 3, and so on.
If you’ve made it this far, you should be jumping out of your seat and shouting, “JC, I want a Preferred Return!” And without knowing anything more, you would be right to think so. However, there’s an old adage that always rings true—you don’t get something for nothing. It’s no different with a Preferred Return. In this case, the Sponsor is giving up their cut of the initial cash flows for a larger percentage of the equity at exit. For now, let’s take a look at how the same Property A would cash flow in a Preferred Return structure.
Example 3: Preferred Return cash flow from operations
Assuming the same property level cash flow for Property A, Table 4 is where we see the differences in the Capital Partners’ share of total cash flow as compared to the JV model. Let’s begin by quantifying the 8% pref. As a reminder, the investor capital is $3M for Property A; so an 8% investor pref equals $240K per year (8% x $3M) on the unreturned investor capital.
On Table 4, the $240K yearly investor pref is referred to as, “Pref Owed,” which is cumulative. Over a five year period, the Pref Owed grows to a sum of $1.200M ($240K x 5), which must be paid to the Capital Partners before any cash flows are paid out to the Sponsor.
However, it’s not a guaranteed return. It’s only paid out if and when the property level cash flows will allow. For example, the total cash flow for Year 1 is only $150K. But the Year 1 pref owed is $240K. In this scenario, the investors receive the $150K (“Pref Paid” in Table 4) and the remaining $90K of “Unpaid Pref” ($150K – $240K) is carried over as a negative “Initial Balance” in Year 2.
Over time, the property level cash flows increase enough that, in Year 5, there is finally sufficient cash flow to cover the cumulative 8% pref with an excess of $90K ($1.290M property level cash flow – $1.200M investor pref). Next, we’ll talk about how the remaining $90K gets split out.
Table 4
| 8% Pref | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total |
| Initial Balance | $0 | ($90,000) | ($120,000) | ($90,000) | ($30,000) | |
| Pref Owed |
($240,000) | ($240,000) | ($240,000) | ($240,000) | ($240,000) | ($1,200,000) |
| Pref Paid |
$150,000 | $210,000 | $270,000 | $300,000 | $270,000 | $1,200,000 |
| Pref Unpaid |
($90,000) | ($120,000) | ($90,000) | ($30,000) | $0 |
Once the cumulative investor pref has been paid out in a PR model, any remaining cash flows are split 70/30. So the remaining $90K is split: $27K to the Sponsor, and $63K to the Capital Partners. Table 5 then provides a summary of how the property level cash flows get paid out in total to the Sponsor and Capital Partners.
Comparing the yearly and total investor cash flows between the JV and Pref models, we can clearly see that the 8% pref produces a net higher and faster ROI during the operational period. For example, the JV model paid out $120K in Year 1, whereas the Pref model paid out $150K in the same year. Similarly, the lifetime cash flows of the JV model paid out only $1.032M, while the Pref model paid out $1.263M.
Table 5
| Property A | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total |
| Total Cash Flow |
$150,000 | $210,000 | $270,000 | $300,000 | $360,000 | $1,290,000 |
| Sponsor Cash Flow | $0 | $0 | $0 | $0 | $27,000 | $27,000 |
| Investor Cash Flow | $150,000 | $210,000 | $270,000 | $300,000 | $333,000 | $1,263,000 |
But don’t go popping the bubbly just yet. There’s still that little thing called a “promote” we need to cover. Remember, you don’t get something for nothing. For a sponsor, that something is a much larger slice of the equity at sale in exchange for paying out an investor pref.
Example 4: Preferred Return equity from sale
The Sponsor Promote is the downside of a Preferred Return model. In exchange for giving the Capital Partners a preferred return, which effectively lowers (but doesn’t eliminate) the Capital Partner’s risk, the Sponsor will typically get promoted to 50% of all remaining cash after return of investor capital. In other words, the Sponsor will collect 50% of equity at sale.
Let’s put some numbers behind the Sponsor Promote. Table 6 shows the same Property A assumptions: purchase price ($10M), loan ($7M), investor capital ($3M), and a sale ($12M). However, the big difference with a Preferred Return model is that once the $3M of investor capital is returned at sale, the Sponsor is now “promoted” to 50% of the remaining equity, which in this case is $1M ($2M x 50%). Compare that to the 20% equity interest in the Joint Venture model where the Sponsor only made $400K at sale. Like I said, you don’t get something for nothing. The Sponsor is rightly entitled to a 50% promote because they have forgone most—if not all—of the operational cash flows for all five years, while still having to do the same amount of work to make the project successful.
Table 6
| Property A | Year 1 Purchase |
Year 5 Sale |
Sponsor Equity | Investor Equity |
| Purchase / Sale | $10,000,000 | $12,000,000 | ||
| Loan | $7,000,000 | ($7,000,000) | ||
| Investor Capital | $3,000,000 | ($3,000,000) | ||
| Equity | $0 | $2,000,000 | $1,000,000 | $1,000,000 |
Now let’s look at how the combined cash flows and exit equity at a property level are split between the Sponsor and the Capital Partners. From Table 7, we see that the Capital Partners did much better on the cash flow returns (as noted earlier) in the PR model, but made -$369K lower total return ($2.263M) compared to the JV model ($2.632M) because they gave up 50% of the equity at sale. On a percentage basis, this means the PR model made (-14.0%) lower total return for the Capital Partners than did the JV model.
The other downside of a PR model is the inherent misalignment of investment interests between the Sponsor and the Capital Partners. From Table 7, it’s easy to see that the only way a Sponsor will make money in the deal is at exit (or a refinance, where loan proceeds are used to pay back investor capital). The Sponsor is incentivized to exit the deal just as quickly as they can, regardless of whether it makes better sense to hold for the longer term. Even if the Capital Partners are happy with dollars back in their collective pockets from a fast exit, they now have to work hard at putting the capital back to work in the shortest amount of time possible. I call this issue the (lost) time-value of money, for all you IRR folks out there.
Table 7
| Property A | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Exit Equity | Total Return |
| Total | $150,000 | $210,000 | $270,000 | $300,000 | $360,000 | $2,000,000 | $3,290,000 |
| Sponsor | $0 | $0 | $0 | $0 | $27,000 | $1,000,000 | $1,027,000 |
| Investor | $150,000 | $210,000 | $270,000 | $300,000 | $333,000 | $1,000,000 | $2,263,000 |
Conclusions
To those who’ve made it this far, I salute you. We’re in the home stretch now, so stay with me! For starters, hopefully you now have a much better understanding of the two basic partnership models: Joint Venture and Preferred Return. What’s clear is that they both have pros and cons from a passive investor’s perspective.
On the plus side, the Preferred Return model will lessen the investor’s risk exposure because you get more of your money back in a shorter amount of time. On the downside, a PR model will typically give you a lower total return (-14.0% for Property A) compared to a Joint Venture model, assuming average deal execution. It’s also important to note that because a Sponsor is taking a 50% promote on the equity at exit, as the equity component becomes a larger slice of the overall returns, the PR model will become progressively less favorable compared to the JV model. Think about it like this, if the same property A was to sell for $14M instead of $12M at exit, then the Capital Partners would have made (-$969K) less in total returns as compared to a JV model. That’s now a (-29.7%) hit to your pocket book. Of course, the downside to the JV model is that you are taking increased front-end risk to make those extra returns.
So which model is a better fit for you? Full disclosure, our company employs a JV model for our Capital Partners and over the last 12 years, for every single deal, they have made significantly greater total returns than they would have in a Preferred Return model. Having said that, I don’t think the JV model is the best solution for all passive investors or even all capital allocations. Remember the part about alignment of investment interests? For passive investors with capital allocations that are more suited to shorter term investment windows and slightly lower risk thresholds, the PR model is certainly worth consideration. However, if your objective is to maximize total returns over a long hold period, then partnering with a like-minded Sponsor who employs a JV model is most likely the better path for you.
About The Author
JC Castillo is an ex-techie turned real estate investor who’s profitably navigated through a full market cycle. In 2006 he founded Multifamily Property Group (MPG), a private equity firm focused on acquiring, renovating and operating large scale value-add apartment properties. Based in the Silicon Valley, JC connects California capital with out-of-state investment opportunities that have made his clients millions in cash flow and many millions more in appreciation. His personal investment philosophy is simple – go long, not short with tax advantaged, cash flowing real estate in quality locations. You can follow JC on LinkedIn or subscribe to the MPG Smart Investing Blog for more tips and advice. To learn about MPG services, Contact Us to set up a complimentary consultation.
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