The Ultimate Syndication Guide: What is a Real Estate Syndication and What to Expect
WHAT IS A REAL ESTATE SYNDICATION?
A real estate syndication is where a group of people pool their resources to purchase real estate – often a large property like an office or apartment building – which would otherwise be difficult or impossible to achieve on their own.
One of the most famous syndications is the purchase of The Empire State Building, which was purchased by Helmsley & Malkin in 1961 for $65 million from 3,000 small investors, many of whom paid only $10,000 for a single share.
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WHO’S INVOLVED IN A SYNDICATION?
A real estate syndication typically involves the “general partners” who organize the syndication, including finding the property, securing financing and managing the property; the general partners are sometimes referred to as the “sponsors” or “operators”.
The group of people who provide the cash investment are often referred to as “passive investors” or “limited partners”. In return for their investment, the limited partners receive an equity share in the syndication along with cash flow distributions and profits.
WHO CAN INVEST IN A REAL ESTATE SYNDICATION?
A real estate investment syndicate is typically open to “accredited investors”. The Securities and Exchange Commission (SEC) defines an accredited investor as someone who has an annual income of $200,000 (or $300,000 joint income) or a net worth of at least $1M—not including your primary residence.
Some syndication offerings, such as the ones designed as “506(b)” offerings – are open to unaccredited investors. Many multifamily syndications are 506(b) offerings, which means they are open to unaccredited investors, but these investors have to be “sophisticated”.
A sophisticated investor has enough knowledge and/or experience in investing in alternative investments such as real estate, oil, or precious metals. They may have made previous investments outside the stock market or perhaps they attended an investing seminar. Whether or not they have actual investing experience, the person has the ability to make an informed decision about a particular syndication offering.
Equally important to being “sophisticated”, the investor needs to have a pre-existing “substantive relationship” with the deal sponsor (i.e. the partner or partners who are presenting the opportunity); although the SEC doesn’t specifically define what “substantive relationship” means.
When you become a client with Realty Capital Analytics you are taken through an initial onboarding process where we gather pertinent information such as financial information and goals, risk tolerance, investment experience, etc.
WHAT KIND OF REAL ESTATE SYNDICATIONS CAN YOU INVEST IN?
Real estate syndications are more common for higher valued commercial real estate – such as multifamily, self-storage, mobile home parks, retail, office or industrial properties.
WHY INVEST IN REAL ESTATE SYNDICATIONS?
There are 5 main reasons investors might consider a real estate syndication over the stock market or other investments:
Below-Average Risk: When the housing bubble popped in 2008, the delinquency rates on Freddie Mac single-family loans soared, hitting 4% in 2010. By contrast, delinquency on multifamily loans peaked at 0.4%.
Above Average Returns: The average stock market return over the last 15 years was 7.04% but after fees, inflation, and taxes that return becomes a paltry 2.5%. On the other hand, multifamily syndications routinely return average annual returns of 10% and above. That’s compounded (i.e. without volatility) and after fees, inflation, and yes, even taxes.
Passive Income: Unlike stocks and bonds, syndications generate cash flow for its investors from the income generated by the property.
Extraordinary Tax Benefits: Because of the magic of “bonus depreciation”, your investment income is taxed at a much lower rate than any other investment (in fact, you may actually show a taxable loss that can be used to offset other passive income).
Inflation Hedge: As inflation increases, so does the value of the property – the perfect hedge against inflation.
WHAT ARE THE RISKS OF INVESTING IN SYNDICATIONS?
There are a number of advantages to putting your money in a multifamily syndication, but every investment comes with risk. Understanding the potential downside to investing in apartments will help you make the best possible choices and ultimately mitigate the risks, putting you on a sweet little road trip to financial freedom. Here are the 5 risks and disadvantages of investing in syndications:
Sensitive to Market Cycles: Like any investment, real estate is affected by market cycles. You can mitigate this risk by investing in real estate like apartment buildings, which has historically performed better than other real estate types in this area.
Highly Dependent on the Operator: Having the right team in place to run a property is also crucial to the performance of a property. If you are dealing with an inexperienced or incompetent operator, they are liable to make mistakes. Mistakes that can cost you a lot of money. To mitigate the risk, ensure that you invest with the right sponsor.
Lack of liquidity: Arguably the biggest disadvantage of investing in syndications is that your money is tied up for 5 years or more. You can’t just call up your broker and sell your position. On the other hand, many syndications can refinance before the end of the term and return part or all of your investment. And in the meantime, you’re hopefully getting cash flow, so you’re getting part of your money back.
Lack of control: Not only is your money tied up for years, but you also don’t control the investment itself – your operator does. They make all of the day to day decisions but they also decide when to refinance or sell. If you’re a control freak, this may be an issue for you. On the other hand, that’s also the benefit of being a passive investor: you don’t have to do anything, just leave it up to your trusted operator.
Harder to understand than investing in stocks: It may seem that understanding an alternative investment like a real estate syndication is hard; and yes, you’re right – there is no doubt a learning curve.
HOW ARE SYNDICATIONS STRUCTURED?
Potential investors have lots of questions about how syndicated deals are structured, and rightfully so.
Here the main components of the structure of a deal:
The Entity
The Sponsor
Equity Splits & The Promote
Debt Structure & Terms
Control & Voting Rights
Preferred Returns
Return of Capital
Sponsor Fees
Let’s dive into some of these in more detail.
THE LEGAL ENTITY
The legal entity most commonly used to structure a syndication is the limited liability company or LLC.
Sometimes sponsors will create multiple entities—a holding company and a local entity in the state where the property is located. The local entity owns the building itself, and the holding company owns the local LLC.
EQUITY SPLITS
Equity splits vary, however, both 70/30 and 80/20 are common. For instance in a 70/30, the limited partners (LPs) get 70% of the ownership, while the general partners (GPs) receive 30%.
The operator earns this portion of the equity known as carried interest for putting the deal together, even though the investors put up 100% of the money.
Our advice is to focus less on the split and more on the returns, specifically the cash-on-cash (CoC) and average annual return (AAR). If you have a good quality deal, a strong operator, conservative underwriting and a 15+% AAR, that’s much more important than the equity split.
PREFERRED RETURNS
Some multifamily syndications offer something called a “preferred return”, which means a certain minimum is paid out to the investors before the general partner is paid.
One way to think of it is like an interest payment, which is paid out first before the leftover cash flow is split based on the equity arrangement.
CHALLENGES WITH PREFERRED RETURNS
The problem with preferred returns is when a project doesn’t go as planned for whatever reason. Maybe the operator is unable to execute on the original business plan, or it takes longer than planned, or there is a market correction.
Regardless of the reason, let’s assume that the available cash flow to be distributed is less than the preferred return. In most cases, the preferred return accrues to the following year.
Now imagine that the situation doesn’t substantially improve, and the general partners fall short of next year’s preferred return and that accrues to the year after that.
If this goes on for too long, the general partners realize they can never catch up to the preferred return. At that point they may stop trying to turn the property around, or they may force a premature sale to get paid something—but neither scenario is actually good for the investors.
CONTROL AND VOTING RIGHTS
The nature of being an LP is that you are limited, both in liability and control. Limited liability means you can only lose the principle you invested in the deal, and you are protected by the SEC in the case of a lawsuit or a loss of the building.
Typically, LPs have no real involvement in the day-to-day operations of the property and all decisions are made by the GP.
LPs almost always have the opportunity to vote on anything that may reduce their rights in any way. And sometimes they can vote over a refinance or sale. The Operating Agreement breaks down the rights of the LPs and GPs, so be sure to read it carefully.
RETURN OF CAPITAL
So, HOW and WHEN do you get your original capital back? Through one of two liquidity events:
Refinance
Sale
The business plan for a deal outlines the hold period, and a good operator will honor that commitment. Under normal circumstances, the plan is to hold the property for five to ten years—unless a market correction takes place. And if the operator is going to change the business plan, they should poll the LPs for input.
SPONSOR FEES
There are several possible fees you may be asked to cover as an LP in a deal:
Acquisition Fees
Development Fees
Asset Management Fees
Capital Raising / Transaction Fees
Disposition Fees
Acquisition fees are the most common. Payable to the GP at closing, this fee is typically 1- 3% of the purchase price.
Asset management fees are typically a percentage of equity or gross collected rents. GPs use this money to cover their overhead for managing the property.
If you are investing in a deal involving ground-up construction, there may be what’s known as a development fee, which goes to cover the sponsors time, effort, and expense related to the design, construction, management, and administration of the development phase of the project.
Capital Raising Fees are a percentage of capital raised, and goes to cover the costs the sponsor incurred to put the deal together, structuring a good offering memorandum, and marketing the deal.
Though it is less common, it is not unheard of to be charged a capital transaction fee. Usually set at approximately 1%, this fee is due when a capital transaction, such as a refinance, occurs.
The final fee you might be asked to pay is known as a disposition fee. This fee is a small percentage of the sale price, and it is collected when the property is sold.
Now you know how a real estate syndication is structured, what some of the terminology is, and what to expect.
WHAT IS THE INVESTMENT PROCESS?
Before I get into the process, I’m going to assume that you’ve decided you want to invest in a syndication opportunity with a specific deal sponsor.
I’m also going to assume that you have a “substantive relationship” with whatever sponsor you intend to invest with. In short, the better you know the deal sponsor, the better they know you, and the more interaction you’ve had, the stronger you can make a case you have a “substantive relationship” and the more likely you’ll be invited to invest in the opportunity.
Assuming you’re ready to go and your sponsor has a live investment opportunity, here is generally what happens next.
STEP #1: LEARN ABOUT THE OPPORTUNITY
Typically the best way to learn about investment opportunities is to get on the syndicator’s email list. In many cases, sponsors will send out regular emails with deals and educational content.
STEP #2: EXPRESS INTEREST VIA A “SOFT COMMIT”
If you’re interested in the opportunity, the next step is typically telling the sponsor how much you’d like to invest in the syndication. The “soft commit” doesn’t put you on the hook yet, but it does give the sponsor an idea of who they can expect to invest in the deal.
STEP #3: REGISTER WITH THE SPONSOR (MANY TIMES THROUGH AN INVESTOR PORTAL)
If you haven’t already registered with the sponsor, you will then do so to provide for effective communication and document exchanges.
STEP #4: SATISFY THE MINIMUM REQUIREMENTS
Next, we double-check that you are either an accredited or sophisticated investor.
If you’re not accredited, and the sponsor doesn’t know you very well yet, you may be asked to hold off until the next syndication.
STEP #5: MAKE A FORMAL INVESTMENT “OFFER”
Those who raised their hand with a “soft commit” now have the chance to let the sponsor know they are serious. At this point, you promise a specific amount of money to the deal.
STEP #6: REVIEW AND SIGN THE LEGAL DOCUMENTS
At this point, you will receive the operating agreement and subscription documents for the deal. These documents will break down the role of the General Partners (GPs) and Limited Partners (LPs), explaining who is responsible for what decisions, risks, disclosures, and also covers profits and splits.
STEP #7: WIRE THE MONEY INTO THE ESCROW ACCOUNT
Once you’ve signed on the dotted line, you receive the wiring information to send your funds to the escrow attorney. Congratulations, you are an LP in a syndicated real estate deal.
STEP #8: WAIT UNTIL CLOSING
Now, you sit back and relax. And wait for the deal to close.