Strategic Approaches to Real Estate Deal Structuring: Enhancing Returns and Managing Investor Expectations

Deal structuring plays a critical role in aligning incentives between partners and investors. It also helps manage risk and set clear expectations from the outset.

This article explores strategic approaches to structuring real estate deals that support long-term outcomes rather than short-term alignment alone.

Understanding how to structure deals is critical for both experienced professionals and those new to the field of capital raising, especially in today’s financial environment. Whether you are just starting or seeking to expand your operations, the choice of deal structure can significantly impact your success.

For newcomers to capital raising, the most common approach is to begin by securing funds through debt instruments.
This method is particularly prevalent in fix-and-flip real estate projects, where hard money loans are often used. These loans are secured by tangible assets, and in the event of a default, the lender can take possession of the asset through foreclosure. Typically, the process involves identifying a property, purchasing it with borrowed funds, and placing a lien on the property. If a default occurs, the lender has the legal right to seize the property.

Building Long-Term Generational Wealth Through Real Estate Ownership

However, scaling this model presents challenges. The loan duration is often tied to the time required to renovate and sell the property, making it difficult to achieve consistent growth.

While transitioning from one property to another is possible, relying solely on fix-and-flip strategies may limit long-term wealth accumulation. To build substantial wealth, it can be more advantageous to diversify beyond these strategies and transition to buy-and-hold real estate, allowing for the long-term benefits of property ownership and control.

Balancing Interests: Financial Structures and Profit Distribution between GPs and LPs

In contrast, the vast majority of deals in today’s market are structured using Limited Partnerships (LPs) and General Partnerships (GPs).
This structure separates ownership from day-to-day operations. This structure delineates two distinct classes of ownership. The General Partner (GP), typically the owner-operator, assumes primary responsibility for managing the investment, while Limited Partners (LPs) provide financial backing.

One of the primary advantages for LP investors is that their risk is limited to their invested capital. They are not responsible for securing financing or managing liability insurance. If legal issues arise at the property level, LPs are generally insulated from direct exposure.

This separation of risk reflects the broader division of responsibilities between the General Partner (GP) and Limited Partners (LPs). While the GP manages operations, financing, and execution, LPs participate financially. Because passive investors typically contribute the majority of the capital—often between 80% and 90% of the total equity—they generally expect terms that reflect their capital contribution.

Preferred Return and Waterfall Basics

To accommodate these expectations, deals are usually structured to offer LPs a preferred return.
This return takes precedence over the GP’s share of the profits. This preferred return generally ranges from 5% to 7% annualized. For example, if an LP invests $100,000, they would expect to receive between $5,000 and $7,000 per year before the GP starts to receive a significant portion of the profits. After the preferred return has been met, any additional profits are distributed according to a predetermined split, known as the “waterfall.”

Common Waterfall Splits and What They Mean

The waterfall distribution typically ranges from a 50/50 to a 70/30 split, meaning that any profits beyond the preferred return are divided between the LP and GP. For instance, in a 70/30 arrangement, the LP would receive 70% of the excess profits, while the GP would receive 30%. This structure is heavily weighted in favor of the LP investor, reflecting their substantial financial contribution to the deal. This framework is commonly used in many real estate investments, ensuring that LPs are adequately compensated before the GP receives a larger share of the profits.

Advanced Structuring Strategies: Enhancing Returns with Additional Share Classes and Preferred Equity

For a more sophisticated approach, you can incorporate an additional tier in the waterfall distribution.
This tier is typically based on an Internal Rate of Return (IRR) hurdle. For instance, a common structure might involve an initial 80/20 split of profits between the LP investors and the General Partner (GP) until the LPs achieve a 15% IRR. Once this threshold is met, the waterfall distribution could shift to favor the GP, adjusting the split from 80/20 to 60/40. This type of arrangement is increasingly prevalent in the current investment climate.

Tiered Equity Classes for Larger Investors

For more advanced structures, some sponsors introduce additional share classes for larger investors. These tiers often apply to contributions of $500,000, $1 million, or more, depending on capital needs and IRR targets.

In a typical structure, investors contributing between $50,000 and $499,000 may receive a 7% preferred return with a 70/30 profit split. Larger investors, however, are often offered improved terms. These may include an 8% preferred return and an 80/20 split.

This tiered approach has become more common with the rise of fund-of-funds models. In these structures, capital is aggregated to qualify for a higher share class, often referred to as Class B shares. The result is a built-in incentive for larger commitments through stronger preferred returns and a more favorable waterfall.

Preferred Equity as a Senior Position

Additionally, some deals introduce a class of shares that sits senior to the typical LP class. This structure is often referred to as preferred equity or private equity.

Preferred equity usually offers limited upside but provides more predictable returns. These returns typically range from 8% to 10% and are often structured as “current pay,” meaning distributions begin immediately on a monthly or quarterly basis.

Because preferred equity sits senior to LP investors, it must be paid before LP distributions begin. In some structures, payments may be deferred and accrue during the hold period, then be settled at the sale of the property.

This approach can be particularly effective in environments where traditional financing is constrained by lower Loan-to-Value (LTV) ratios or debt service coverage ratios. By implementing these strategies, you can enhance your investment returns and offer more attractive terms to larger investors, leveraging a tool that adds significant value to your capital-raising efforts.

When This Structure Fits and Who It’s For

For typical Limited Partners (LPs), aiming for a 14% or 16% IRR might be standard practice. However, consider the potential benefits of incorporating an additional preferred equity class. This class may target a lower IRR, such as 7%, 8%, or 9%, but offers increased cash flow.

This strategy serves two purposes. It can improve overall returns for LP investors while generating more immediate cash flow. This structure is especially attractive to investors who prioritize steady income, such as those using retirement accounts or cash-flow-focused portfolios.

Disclaimer: This information is provided for educational purposes only and does not constitute tax or legal advice. Readers should consult with their own professional advisors for tailored guidance.

Interested in how experienced investors structure deals and partnerships?
Learn more about the MIH Multifamily Mastermind and the frameworks used to align incentives and manage investor expectations.