Yes, you can, but we NEVER advise it. Our clients who have tried this have alienated their investors, and after the deal was over, said they would never do it again. The perception of investors is that they took all of the risk, but management kept the windfall. If the property sells for much more later, investors feel cheated.
Additionally, it rarely works, as buying investors out requires paying back all of their original investment plus all accrued preferred returns and splits as if a sale had occurred. Most cash-out refinances don’t yield enough cash to do it. Very typically, you might get enough to pay back half of the investors’ original investment, or enough to buy out a specific class of investors. Since preferred returns are only owed on “unreturned capial contributions,” a partial payback means there is more cash flow post-refinance to split between the investors and management classes after preferred returns are paid against the investors’ unreturned capital.
Your goal as a syndicator should be to develop a loyal group of investors who invest with you again and again. Here are two options that do work:
- Set a cap on investor returns such that once investors get all of their money back plus a healthy annualized return of, say 18%-20%, the split changes to something else, like 50/50, or it reverses. For instance, if the split was previously 70/30 with 70% to investors and 30% to management, from that point forward it’s 30/70. This is acceptable to investors as it gives you incentive to hit their targets, and if you do, you get a nice reward for achieving their goal.
- If you have some investors who don’t want to stay in long-term, you can offer them a priority class with a fixed return, with the idea that they get paid back their investment plus all accrued returns on refinance. Fixed-return investors are typically a non-voting class, and some of our clients even offer them monthly returns; i.e., they get paid right after the lender and other operating expenses of the property are paid. However, beware of offering a fixed return that is too high, i.e., 12%, or offering it to too many investors, as it can kill the returns to other investors and management until you refinance and buy the fixed-return class out. Once fixed-return investors are paid back their investment plus accrued returns, they relinquish their interests, leaving the cash flow and equity realized on sale for the equity investors and management. (Pro Tip — This model works great for seller financing, as commercial lenders typically won’t allow subordinate debt, but they will allow a fixed-return class in your entity that has the same terms as a loan without foreclosure rights.)