Understanding Real Estate Syndications

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Understanding Real Estate Syndications

INTRODUCTION

As a landlord, if waking up at 2 AM to fix a plumbing emergency isn’t something you want to deal with, then this passive real estate investment strategy might be the thing you’re looking for. The art of teaming up to acquire real estate isn’t new, but surprisingly enough, not many people know what it is or how it works. So, in this article, I will focus on a specific type of passive real estate investment tool known as the Real Estate Syndication.

A real estate syndication is a group of two or more investors or investment companies coming together for a common goal; to raise capital for purchasing real estate or building a new property. The advantage of pooling your money with other investors is that you can invest in a much bigger, more lucrative deal that could be otherwise too expensive for an individual investor. In addition, unlike a REIT (Real Estate Investment Trust), the asset is already identified in a syndication, and the investors raise money for that specific opportunity.

Brief History of Real Estate Syndication

Historically speaking, a real estate entrepreneur or a sponsor could publicly advertise and solicit private funding from anywhere up until the initiation of the Securities Act of 1933. After which, all new private offerings are required to be registered with the Securities Exchange Commission (SEC). The SEC passed this rule to protect the investors from fraud, but it also seemed to stall the syndication process making it far less efficient. 

However, the SEC offered few exemptions that allowed sponsors to skip registration under specific conditions:

  • raise money through private solicitation and avoid registration or
  • register with the SEC, wait for approval, and then solicit public funding. 

The first option almost always seemed more efficient to the sponsors, and despite the securities act regulating public solicitation, private syndication continued. 

The general solicitation rules were further relaxed by the JOBS Act of 2012, which allowed investors to participate as long as certain criteria were met and each investor was accredited. An accredited investor is someone who has:

  • an annual income of $200,000 for the past two years (or $300,000 if married)
  • a net worth of at least $1 Million, excluding the private residence (filing individually or jointly)

Syndication Framework

Real estate syndication is a legal transaction between two parties – the Sponsor / Syndicator / General Partner (GP) and the investors / Limited Partners (LP). Legally, a syndicate can be structured as a Limited Partnership (LP) or Limited Liability Company (LLC). A sponsor’s role is to scout out a property, seek funding, and manage day-to-day operations while the investors provide the majority of the financial support. A sponsor should have sufficient experience in real estate investing and the ability to underwrite and do due diligence on the potential investment opportunity. In addition, a sponsor usually invests between 5 to 20% of the total required equity. Needless to say, the more skin a sponsor has in a deal, the better it is for the investors. 

Hire a real estate attorney to put together a contract that clearly lays out distributions, voting rights, sponsor’s right to property management fees, communication requirements, and so on to protect all parties involved. Consider scheduling quarterly meetings to discuss the property’s progress and next steps. 

How is a Syndication different from a Trust or a Fund?

On the surface, a real estate syndication might look fairly similar to a real estate trust, but there are quite a few differences between the two.

Real Estate Investment Trust (REIT)

  • It is modeled after a mutual fund that owns, operates, or funds income-generating properties
  • It offers a steady income stream by paying out dividends to its investors but offers little in terms of capital appreciation
  • REITs are publicly traded like stocks which makes them highly liquid assets

Real Estate Syndication

  • This strategy invests in a physical real estate asset
  • Investors are locked in for the agreed term, and the sponsor decides on when to sell or refinance the property 
  • It offers access to large, lucrative investment opportunities with property management services
  • Also, offers several tax benefits like 1031 exchange, pass-through deductions, and asset depreciation

How does a Syndication make money?

A sponsor and his limited partners make money through two primary sources – property appreciation and rental income. Rental income is distributed amongst the investors by the sponsor on a monthly or quarterly basis. With time as the property’s value keeps appreciating, investors typically net higher rental income and eventually make large profits upon sale. The duration of a syndication varies per sponsor and the type of property. While some syndications are over within a year, others might run for 7 to 10 years. However, typically a syndication lasts for 3 to 7 years. And each invested party receives a share of the profits per the agreed terms and conditions. 

A sponsor often takes an upfront profit share for sourcing and acquiring a deal, called the acquisition fee, and it typically averages around 1% of the property value. In addition to profit-sharing, most syndications offer what is called the “preferred return.” This means when distributions are made, an investor is in a preferred position until they meet the preferred return hurdle. Meaning the real estate property isn’t producing enough cash flow to keep this promise. Preferred returns usually range between 5 to 10% annually of the initial capital investment. 

Final Thoughts

Syndication allows you to diversify your portfolio as you’re only investing a small sum at a time and might still have the ability to explore other types of investment opportunities without being tied to a single property. Moreover, as an investor, syndication is one of the most passive investment ideas that require little effort upfront for a killer return on investment.

However, it helps to understand some of the syndication disadvantages, like the lack of liquidity and control over the property as you’re locked in for a said term. Also, your sponsor chooses whether to sell or refinance. Further, unlike ownership, you don’t have the opportunity to build long-term equity in an asset. 

After all, like any other investment tool, investing in real estate syndications has its pros and cons. As an investor, it’s imperative that you understand the basics to perform preliminary due diligence on your part and, more importantly, agree if this strategy will help you achieve your financial goals. Remember, you don’t have to choose one or the other; you can still invest in a syndication while already invested in a property or a trust. As investing in passive real estate with necessary due diligence is always a win in my book! Good luck!


Journal Club 6-26-20 Investor Club