Pari Passu is a concept used in law, finance, and commercial real estate investing. Generally, it refers to the idea that two or more assets, creditors, investors, or securities should be treated equally without preference. This concept is usually seen in bankruptcy proceedings or financial contracts.
Commercial real estate investors should understand the concept of pari passu, its implications for their portfolio, and its integration into financial contracts. To begin, let’s explore the origin of the term.
Pari Passu Definition
The phrase pari passu comes from Latin and literally means “with even steps,” but is more commonly translated as ”on equal footing.” It refers to classes of things—assets, creditors, obligations, or securities—and conveys the idea that all members of that class are on equal footing in how they are addressed or treated.
“Equal Footing” in Financial Contracts
In commercial real estate partnerships, pari passu clauses are often written into contracts to ensure the partners receive equal treatment regarding when and how payouts are distributed. Most commonly, pari passu clauses are added to waterfall structures and commercial mortgage-backed securities to ensure the partners in these agreements receive equal treatment without preference.
Note that this doesn’t necessarily mean each partner collects the same amount at the payout. Instead, each partner gets paid simultaneously and is treated as part of the same class, even if the dollar amounts differ.
Pari Passu vs. Pro Rata Share
In commercial real estate investing, pro rata means all partners get an even proportion of the payout (pro rata means proportional in Latin, after all). Newcomers to commercial real estate investing often confuse pari passu, which describes how an asset, investor, or creditor is treated, with pro rata, which describes the distribution.
Investors need to understand this difference.
On the surface, both concepts seem to be two different ways of saying the same thing. This is because investors or partners who are all pari passu often receive pro rata shares up to a point. In some sense, they go hand-in-hand.
However, a group of pari passu investors can receive different payout amounts due to the specifics of their financial contract. Pari passu simply means all the investors are treated as the same class and paid simultaneously. Though it can also mean they are paid the same amount, this doesn’t have to be the case.
To understand how this works, investors should know the types of commercial real estate agreements that utilize pari passu clauses.
Pari Passu and Payouts in Commercial Real Estate Operating Agreements
Commercial real estate operating agreements are legal contracts defining how, when, and to whom profits are distributed among the partners in the agreement. Most private equity investment firms use waterfall structures in their operating agreements.
Waterfall Structures in CRE Partnerships
In essence, waterfall structures refer to method by which cash flow or profits from a capital event—like a property sale—are distributed between the general partner, who makes most of the decisions and takes on most of the risk, and the limited partners, who provide capital but don’t play a managerial role in the investment.
In waterfall structures, general partners usually receive what’s called a “promote,” which is also referred to as an outsized profit share. This is because the general partner has a more significant role in finding opportunities, negotiating with sellers, taking on risks, and performing due diligence on a property than limited partners.
Pari Passu in Waterfall Structures
However, in most waterfall structures, this promote, which accounts for the extra work general partners put into an investment, doesn’t apply until profits exceed the internal rate of return (IRR). This return hurdle is given as a percentage in operating agreements. For this article, let’s use 10%.
In waterfall structures, both the general partner and limited partners are treated pari passu and are paid pro rata until the IRR is reached. Once the IRR exceeds 10%, the general partner receives a larger percentage of profits.
Some waterfall structures stipulate multiple return hurdles, which increase the percentage the general partner takes the higher the ROI grows.
The series of return hurdles can look like this: the general partner receives 12% of all profits beyond the IRR of 10%, but they take a larger percentage of the profits as the profits increase.
The GP will take:
- 15% of profits past 20%
- 20% of profits past 25%
- 25% of profits past 30%
However, the general partner and the limited partners are considered pari passu before that 10% profit is made. After the IRR is surpassed, only the limited partners are considered pari passu. The general partner receives a larger share of the profits.
Commercial Mortgage-backed Securities (CMBS)
Pari passu is also used in another area of commercial real estate—commercial mortgage-backed securities. CMBS are fixed-income investment products backed by mortgages on commercial real estate rather than residential mortgages.
CMBS loans are grouped into real estate mortgage investment conduit trusts, or REMICs, and are available as an investment asset class on the secondary market.
Pari Passu in CMBS
To mitigate risk, CMBS loans break up into two classes of notes that investors can purchase across several bonds:
- A-notes, or primary notes
- B-notes, or subordinate notes
A-notes pay investors first and are considered more secure. B-notes only pay out after A-notes have paid out and might not pay out if the A-notes default. However, the interest rates on B-notes are higher, increasing the risk and the reward.
A-notes are considered pari passu notes, and they pay out at the same time. The holders of A-notes all receive the same treatment. B-notes are not pari passu because they do not receive equal treatment.
To sum, pari passu notes help spread the risk associated with massive commercial mortgages across multiple CMBS.
The Importance of Understanding Cash Flow Distribution For Investors
Pari passu is an essential part of commercial real estate investing. Accredited investors need to read operating agreements to fully grasp how their investments pay out. Understanding how waterfall structures work gives you an edge over other investors who might not take the time and do their due diligence.
The Benefits of Pari Passu
Pari passu is an integral part of commercial real estate partnerships and helps make investing more equitable for partners. Knowing you are on equal footing with other investors helps establish trust and a sense of security for accredited investors.
With CMBS, pari passu structures help finance massive commercial real estate projects by splitting the risk across A-notes and B-notes. Pari passu structures also help increase liquidity for commercial real estate investment firms.
Drawbacks of Pari Passu in CMBS
Regarding CMBS, pari passu notes take an already complicated financial system and make it more complex. Credit rating agencies have expressed concerns that pari passu note holders are difficult to track down and keep track of.
Because the holders of pari passu notes are decentralized, it takes longer to resolve issues and reach a consensus among note holders. This increases the chances that a loan will default.
Pari Passu in Real Estate Syndication Investments
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If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.