How does someone start syndicating real estate? This post will be just a broad overview…
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How to Start a Real Estate Syndication
- Determine your Founders’ Investment Theory
- Form the Sponsor LLC
- Put together the syndication team
- Begin finding investors
- Begin finding properties
- Conduct financial analysis of property prospects
- Test property prospects with key investors
- Lock up property
- Form Investment LLC
- Hire attorney to prepare syndication documents
- Raise funds from investors
- Close on property
Real Estate Syndication Overview
Real estate has been one of the most important global wealth drivers for hundreds of years. When you own land or property, you can make money in so many ways, whether in the residential, commercial, industrial, or agricultural sectors.
On top of that, real estate has proven more reliable than stock or commodity markets over the years. Despite multiple real estate market crashes, things always bounce back, and prices reach new heights.
Everything revolves around real estate. Whether it’s people needing homes, companies leasing office space, developing retail centers, or anything else in between – real estate is at the core.
These days, commercial real estate is gaining traction like never before, thanks to more investors being open-minded about diversifying their investment portfolios outside the traditional asset classes.
And just like the stock market, the real estate industry offers no shortage of opportunities in terms of properties and investment methods. Arguably the new kid on the block is syndicated real estate.
Its appeal lies in the combined power of multiple investors coming together to buy and operate income-generating properties. But real estate syndication, although easy enough to understand, is a complex topic and somewhat challenging to pull off if you don’t know what you’re doing.
That’s why many issuers or sponsors of these deals can end up losing money instead of turning a profit.
To give you a better sense of what it demands, this article will tell you what you need to know about syndication, its legal form, dealing with investors, and how it differs from another popular form of group investment – REITs.
Forms of Syndication
From a securities standpoint, most syndications are offered to investors using Regulation D Rule 506(b) or 506(c), but Regulation CF and Regulation A are common as well. In terms of structure, nearly all are formed as limited liability companies.
This is either the person or the business that scouts for income-generating properties but doesn’t have the capital to invest. Therefore, they raise funds from accredited investors to close the deal, ultimately splitting the profits based on a pre-determined structure.
These are people with either a net worth of over $1 million or with an income in excess of $200,000 per year (individuals) or $300,000 for spouses. Accredited investors are allowed to invest in any Regulation D offerings, such as real estate syndications.
A non-accredited investor doesn’t meet the SEC’s net worth or income requirements to invest in Regulation D offerings. However, non-accredited investors can be considered sophisticated investors if they have knowledge of the space in which they’re investing.
The term refers to private, off-the-market offerings in which investors can elect to finance a real estate deal for an income-generating property as it is presented by the deal’s sponsor or syndicator.
The SEC regulation governs real estate syndications and enables deal sponsors to raise capital, with various exemptions, depending on what rules they prefer to follow for their venture.
Before splitting the profits with the sponsor, investors receive monthly, quarterly, or annual payments proportional to a specific percentage of the initial investment. Such payments are called the preferred return.
Crowdfunding can be a method of finding investors through specialized online platforms. At the same time, it can be a type of syndication in its own right, although it comes with strict limitations on capital, as mandated by the SEC.
Sponsors have multiple revenue streams when it comes to syndication deals. On top of sharing in the profits, sponsors can also set various fees depending on the management tasks they accomplish.
The PPM, or private placement memorandum, is a very important document drafted by the sponsor for the investors and serves as a disclosure paper of sorts, informing investors of all the particularities of an offering.
This term is used to describe the deal itself, put forth by the sponsor with specific terms associated with it.
This is a profit distribution or payment distribution structure typically found in most real estate syndication ventures.
What Makes a Real Estate Syndicate
When a sponsor and their investors engage in syndication for the purpose of purchasing an income-generating property, their partnership becomes a real estate syndicate. Sometimes, the engagement is one where the sponsor manages a pool of investment capital to purchase at their discretion – this is a real estate fund. In both cases, it’s defined as a contractual agreement in which investors pool their money to invest in large commercial properties.
While the sponsor takes the active role of a general partner, passive investors don’t have to do anything but finance the deal and agree to share the profits with the sponsor.
Common targets of real estate syndication companies may include apartment complexes, retail centers, warehouses, office buildings, or even raw land ready for development.
The Fundamentals of Starting Real Estate Syndication Companies
Before going forward with your first venture in syndication, real estate knowledge is required, along with an understanding of the specifics involved in this type of partnership agreement.
The Mandate of Syndication Companies
Any real estate syndicate is led by one or more professional deal sponsor. One of their first duties is to find opportunities on the property market to buy income-producing properties, mostly through research and networking.
The sponsor is also tasked with negotiating the buying price for the properties found. From there, sponsors have to create a solid business plan outlining the optimal operation of the property and figuring out how to maximize its cash flow potential, usually through rental income.
Since most syndication deals don’t involve long-term arrangements, the sponsor has to plan to increase the property’s value to ensure making a good profit once selling the unit.
Things such as inspections, audits, and title work fall into the category of due diligence. Again, this is something that the sponsor will handle as the investors are passive partners who rarely know enough about the real estate sector to contribute.
A real estate syndicate has to become a legal entity separate from the sponsor and investors. Therefore, the sponsor is tasked with creating all the necessary paperwork and filing documents to make the syndicate legal, compliant, and enforceable.
As already mentioned, the sponsor needs to figure out how to find investors for real estate deals and raise real estate capital through networking, presenting their offer, and educating would-be accredited or sophisticated investors on the proposed deal.
Because not all syndication offerings involve purchasing a building with money down, a sponsor may have to take care of mortgage loan applications. After getting the investors on board and the necessary capital, sponsors proceed to close the deal with the seller and transition the property to its new ownership – the syndicate.
Then, sponsors take over the daily operations. This could involve renovation work, starting development, or quickly finding tenants if the property is in good standing. Sponsors can do these things themselves or elect to outsource some of the work.
During their time as general partners and managers, the sponsors should keep the passive investors apprised of their asset. This means informing them of the building’s condition and progression of the business plan.
As the property starts generating profits, it’s up to the sponsor to check the distribution structure, collect the money, and divide it out to the passive investors according to the pre-determined terms of their agreement.
As the term of the deal reaches its end, the sponsor has to identify the best way to sell the property, if it appreciates in value, and maximize the profits from the sale. After that, they once again distribute cash proceeds according to the pre-determined split formula.
These cover the attributes and duties of a real estate syndication sponsor regarding the asset and its investors.
The Pros of a Real Estate Syndication Company
In most cases, sponsors have knowledge of the industry but lack the capital to make sizeable investments in commercial real estate. Therefore, pooling the resources of multiple investors allows access to larger properties, better financing options, and great scaling potential.
Furthermore, despite being tasked with all of the work, the sponsor remains at an advantage. They will operate in an area that they’re comfortable in and have complete control over the terms of the deal and the subsequent operations for the duration of the term.
On top of that, by raising money from investors, the sponsor reduces their own financial risk. The only way sponsors or real estate syndication companies can lose money is if they drop the ball with managing the property.
The Cons of a Real Estate Syndication Company
Due to the similarity of syndicated real estate and issuing securities, the SEC governs this segment of the industry. As a result, sponsors must adhere to somewhat strict SEC regulations involving who they can raise money from and how much they can pool for particular deals.
Furthermore, some commercial loans can still be very difficult to qualify for; thus, sponsors might have to go into an expensive partnership agreement.
Although typically sponsors don’t put their own money into a deal, this isn’t a luxury everyone can afford. When just starting to build a name in the syndication niche, passive investors may prefer it if the sponsor has skin in the game and contributes some of their own money.
It can make it seem like less of a gamble and a move that presumably motivates the sponsor even further to improve their management efforts.
How to Start a Real Estate Syndication Company
One of the first things to address is the niche. Syndication offers many opportunities in different market segments and across multiple property classes. However, casting a wide net is not an efficient way to research and scout for lucrative opportunities.
Therefore, the first step in starting your syndication venture is to specialize in a specific type of property. From there, outline and set the company goals. Think about what buying strategy you’d prefer to use and what type of projects you have in mind.
Do you want to maximize rental income or develop?
Working based on that information, you have to calculate a realistic internal rate of return (IRR) for each property you have your eyes on. Draft a comprehensive business plan and a mission statement to better define both your strategy and purpose in this segment of the real estate industry.
Once you know what you want to achieve, you have to consider building a team. Although you can be an individual sponsor, the larger the property, the harder it is to manage. Besides, you might need a good real estate syndication attorney and even an SEC attorney to ensure you’re compliant with all regulations.
A mortgage broker and an insurance broker can help you find better deals and access more financing options, thus reducing the financial strain on yourself and your passive investors.
Given that some syndicates go after massive apartment complexes, the management of hundreds of tenants can be increasingly difficult over time without a property management company that can assist along the way.
So, if you’re not ready to build a team, it’s still good practice to identify the roles you would need based on your mission statement and investment strategy.
After that’s settled, it’s time for probably the toughest task of all – networking and creating an investor database. The biggest mistake sponsors often make is that they start looking for deals and go after investors.
But that’s never a good approach. First of all, with a deal under contract, you could be subject to a time constraint that won’t allow you to find and convince investors to join your deal.
Secondly, some SEC regulations require you to know your investors before raising capital from them. Fortunately, this doesn’t always imply a previous partnership. However, an existing relationship is preferred. That’s why you have to meet potential investors before you have any deals to offer them.
Structuring Your Syndicate
When registering a real estate syndication, sponsors have three options: corporation, limited liability company, and limited partnership.
This business structure enables a company to become a legal entity, separate from its owners.
Limited Liability Company
This is probably the most desirable structure when talking about property investment syndicates. One of its biggest advantages is that owners aren’t held liable for company debt. They’re only responsible for the amount of cash invested.
Created between two or more partners, a limited partnership differs slightly from a limited liability company. With this structure, some partners may enjoy the benefits of limited liability, while others could be held responsible for more than the amount they’ve invested.
Whether you choose an LP or LLC structure, the agreement must give all partners voting rights. Also, the contract should ensure the right to distribute positive cash flow and state the compensation rights and responsibilities of the sponsor.
Making Money From Real Estate Syndication
Passive investors can expect three revenue streams from a syndicated property deal. First, they receive a percentage of their investment back in the form of preferred returns based on a pre-determined annualized rate.
Secondly, they earn a share of the profits coming from rental income. Lastly, if all goes well and the value of the asset appreciates, investors can get another chunk of profit from the sale of the asset.
On the other hand, sponsors have more ways to monetize their involvement in real estate syndication. Before the property starts generating profits, sponsors are entitled to property acquisition fees, usually between .5% and 2% of the initial cash investment.
Then, sponsors may also exercise their right to take property management fees for their work in handling daily operations. If the sponsors also have skin in the game, then the sponsor would also enjoy a share of the rental income profits, based on the equity they hold.
Finally, a sponsor can get a share of the sale profits.
It’s also worth noting that various payment structures can be implemented in real estate syndications. That means sponsors can increase their return based on performance by hitting certain internal revenue rates (IRR).
Distribution of Funds
Aside from adhering to the SEC regulations and other legal aspects of running a real estate syndicate, sponsors have another essential aspect to consider – the distribution of funds.
That essentially means structuring the payment plan and deciding how to split the profits between themselves and investors.
This usually starts by setting a preferred return of 8% to 10% for the investors. In most cases, the preferred return gets prioritized before any other excess cash gets distributed between the partners. Although there are exceptions to this rule, it’s often desirable and can make investors more motivated to enter a deal.
After paying the preferred return, sponsors also take their share according to the agreed-upon profit split structure, typically 80/20 or 70/30, in favor of the passive investors.
But the cash flow distribution is a complex topic, worth going into in more detail.
To fully understand how this works, you have to learn about the waterfall structure.
Simply put, the waterfall cash flow distribution structure mimics the flow of water. As the water reaches a certain threshold or hurdle, it overflows, goes over a ledge, and falls into another body of water. Depending on the terrain, it can do this multiple times, which is known as a cascading waterfall.
Something similar happens to the cash distribution system. The cash flow represents the water, while the hurdles are the IRR levels stipulated in the contract.
Here’s a simple example of how it works.
The sponsor and investors agree on an 8% preferred return and an 80/20 split until reaching a 15% IRR. That means that investors first get their preferred return for their share in the income-generating property.
Then, the remaining money gets split between the limited partners and sponsor, with the sponsor being entitled to 20%. However, if the property’s performance goes over the 15% IRR to say 20% IRR, the sponsor could be entitled to a larger share of the profits, for instance, a 30% chunk of excess cash.
In most real estate syndication deals, the waterfall structure is very simple, often accounting for one or two IRR hurdles. But sponsors can make these systems more complex to boost their revenue consistently upon reaching certain targets.
Of course, everything related to the profit distribution has to be stipulated in the partnership agreement. Sponsors can’t alter the split after outperforming if there are no provisions to account for specific IRR hurdles.
Calculating the IRR, and the preferred return, for that matter, is done on a deal-by-deal basis. Each property has unique investment requirements and income potential, so there’s no standard rate you can apply across the board.
That said, staying within the 5% to 10% range for the preferred return is more than enough. Most investors expect an 8% annualized return; thus, going lower might make it more difficult to raise capital.
When it comes to the IRR, the majority of investors should feel comfortable with the 12% to 15% range for the first threshold. Investors won’t mind the sponsor earning a more significant share of the profits, no matter how things progress, as long as they can outperform.
Multiple reward tiers generally incentivize sponsors to stay on top of their game and outperform, which means that investors also stand to earn more.
The Standard Two-Tiered Waterfall Structure
Considered a step above the standard waterfall structure, this distribution model calls for two reward tiers. As such, sponsors can refer to two sets of rules when splitting profits from the operating cash flow and capital events.
For example, reaching a certain IRR of 15% or 20% would entitle sponsors to change the initial profit split from 80/20 to 70/30 or 65/35. Then, a different division could be agreed upon that goes into effect once the sponsor refinances the deal or sells the property.
Waterfalls and Partnership Classes
If you’re unfamiliar with how stocks work, know that they can be categorized into preferred stocks, Class B, C, or even D stocks. Each stock class has a different price tag and entitles the shareholders of that category to a particular dividend, along with other potential benefits.
Well, a similar structure can be applied to separate different classes of investors in a syndication partnership. For instance, some partners could be loyal investors – they’ve joined the sponsor on multiple syndication deals. As a result, they could receive higher rewards from the sponsor compared to other partners.
Furthermore, some people could contribute less money to the deal and fall into a different profit split category. This is usually when waterfall payment structures can get complex and feature up to 10 layers of hurdles, provisions, and other stipulations that trigger specific payment splits between the sponsor and limited partners.
To keep things simple, know that Class A partners are pretty much like premium investors, and the others are one or two steps below.
Class A limited partners may qualify for a 10% preferred return and 80/20 split of the profits within a waterfall structure. But Class B partners could max out at an 8% return and get only 70% of the profits, with the sponsor earning a bigger share in this context.
Critical Documentation – The Private Placement Memorandum Checklist
What is a Reg D Private Placement Memorandum? It’s very similar to a disclosure document in which the sponsor gives would-be investors all the information they need to understand the offering in front of them.
Sometimes it’s easy to confuse a PPM document with a business plan. While it does touch on the strategy to run the business, a PPM checklist is much more complex and detailed. You can use a private placement memorandum template to get started. Still, it’s necessary to realize that certain sections or points of emphasis with real estate may differ from those of a regular business.
You can start a private placement memorandum with a concise overview of the offering and the company. It notifies the investors of the concept behind the investment and tells them who you are.
The investment summary section goes into more detail about the investment. This is where would-be investors can learn about the property, why it’s a good deal, what they can expect, and the plan to manage it.
Risk factors occupy their own section of the PPM document. The SEC mandates that investors are made fully aware of any risks involved with putting their capital into an offering. As such, it’s best to describe everything from general risk factors within the real estate industry as a whole and potential challenges specific to your offer. It usually includes things like natural disasters, local market conditions, economic issues, structural problems, and even tenant trends.
While the summary gives investors an idea of who you are, a different section of the PPM paperwork will detail this. Explain your track record to build trust, your financial condition, and any other third parties involved in the deal – management companies, attorneys, brokers, etc.
The PPM also serves to inform investors on the use of their capital investment before and after closing the deal. Furthermore, it’s essential to notify potential investors of the proposed rate of return, the term of the agreement, and the payment structure with the various profit splits you have planned.
Give investors a clear overview of any fees you might incur for your management efforts and discuss the aspects of liquidity and transferability.
Another crucial aspect is potential conflicts of interest that require full disclosure in the document.
For a more comprehensive document, it’s worth adding in any taxation information, whether it involves certain incentives or downsides, and clearly outline the ideal investor profile that fits your offering.
The SEC calls for very detailed PPM documents in an attempt to protect accredited investors from making bad decisions. Therefore, the sponsor is tasked with providing as much information as possible to educate investors. Hence, the PPM is one of the most vital real estate syndication documents.
Understanding the SEC’s Regulation D
Creating a business plan, finding investors, and drafting a payment structure can only get you so far. If you want to learn how to start a real estate investment group, you also have to understand the rules that govern syndications in the real estate industry. The SEC regulations can be restrictive in some regards and loose in others, depending on what you’re trying to accomplish with your syndicate.
As it relates to this topic, the number one mandate you have to know is called Regulation D.
This ruleset determines how much money sponsors can raise, what they can buy, and what type of investors they can work with on a particular deal. Therefore, handling the Form D filing and understanding the provisions falls on the sponsor or syndicator.
Two rules are critical here – Regulation D rule 506 with its provisions Reg D 506(b) and Reg D 506(c).
The SEC Rule 506 first variant allows sponsors to raise capital from as many accredited investors as they want. There’s no limit on the number of partners or on the capital raised for the investment.
Furthermore, filing for this rule enables syndicators to raise money from non-accredited investors too. This means that along with accredited investors, up to 35 sophisticated partners can join the deal – provided that they meet the sophisticated status and make up for their lack of capital with real estate knowledge.
The only drawback to a Regulation D offering of this type is that sponsors aren’t allowed to advertise and market their offer. That means that there’s no room for crowdfunding efforts.
Under Reg D 506(c), things are a bit different. For one, sophisticated investors can’t participate in the joint venture. But sponsors still have access to unlimited capital and a number of passive partners, so long as they’re accredited and verified by the syndicator.
Marketing is allowed in this instance, which can make it easier to find investors and close deals faster. Rule 506(c) can create opportunities for going after bigger apartment complexes and other commercial real estate properties.
Apart from these options, you also have Regulation A+ offerings to consider. Unlike previous alternatives, Reg A puts a cap on your capital of $50 million. It also prevents the resulting real estate syndicate from being publicly listed.
Despite its limitation, this regulation does have some benefits. Mainly, it enables sponsors to select from a pool of accredited and non-accredited investors and engage in marketing efforts to raise capital for their investment.
Navigating the complexities of the SEC regulations may require the help of a syndication attorney, at least on the first couple of offerings.
How to Start a REIT Company
Now that you know how to start a real estate syndication company, it’s time to have a discussion about starting a REIT. Why?
It’s because a syndicate and REIT can often seem very similar and may even be used interchangeably.
REIT stands for Real Estate Investment Trust. It’s a legal entity in its own rights yet harbors many differences from your traditional limited partnership that results from real estate syndication efforts.
One of the biggest differences between a REIT and a real estate syndicate is ownership. Through syndication, the limited partners buy direct ownership in a property and receive a return based on how much they own and other factors stipulated in the payment structure.
With REITs, there’s no direct ownership of property. A REIT is a trust that buys and manages real estate. It can own thousands of properties. When an investor buys shares in a REIT, they receive ownership in the company itself, but not its properties. This means that investors, or shareholders, receive payment in the form of dividends based on the REIT’s profit from their income-generating properties.
Of course, there are other differences worth considering.
REITs can have vast portfolios diversified across multiple markets. This makes it difficult for investors to keep track of everything and get a sense of how the trust manages each property.
With syndication, things are simpler. Generally, a real estate syndicate will buy a single piece of commercial real estate. REITs operate more like blind funds, whereas syndication allows you to target specific property assets.
It’s not difficult to invest in a REIT as they’re featured on all major stock exchanges. You can gain ownership in a REIT through mutual funds, by buying directly, and various other means. Furthermore, given the recent popularization of fractional share trading, investors can put whatever amount they want into a REIT – whether it’s $50 or upwards of $50,000.
Syndications are not as accessible. Their visibility depends on the sponsor doing a good job of networking and putting their offering in front of interested investors. Furthermore, public advertising is illegal when filed under a specific SEC regulation, such as rule 506(b).
A REIT can be a more attractive option in terms of immediate appeal for the average investor with no experience in real estate. It takes minutes to invest, doesn’t cost much, and you have tons of options to choose from.
Buying into a REIT doesn’t give investors a share of the underlying real estate – only in the company controlling the assets.
Syndication offers direct ownership of a property. This means voting rights, making management decisions, choosing when to raise the rent or sell the building.
The Liquidity Aspect
A REIT is often more liquid than a property owned by a real estate syndicate. Unlike the latter, which depends on reaching maturity before turning a profit from financing or reselling, REIT shares are traded every day.
Sure, those shares can lose their value over time, can drop when the market crashes, and investors can lose their money. But they can also make a quick profit by making the right investment decisions.
Syndications are not always long-term, yet the majority of offerings call for at least a five-year deal term. During that time, investors only profit from the cash flow that the asset generates.
This is where syndication has the edge. Most investors might not know this, but investment properties enjoy various tax benefits such as deductions and depreciation. Sometimes, the depreciation benefits can surpass the generated cash flow.
On the other hand, REITs don’t offer the same benefits and incentives. Again, this has to do with the ownership structure. Since investors aren’t buying a stake in the property assets but rather the company owning the real estate, there aren’t many benefits.
Naturally, depreciation still applies to the properties that the trust controls. However, REITs account for those benefits before calculating the dividend given out to shareholders. Therefore investors don’t get tax breaks.
Before going further, it’s important to understand one thing. Syndicated real estate can have high yields or lose money. It all depends on how good the sponsor is at choosing a property, creating a business plan and strategy for it if the asset appreciates enough, and so on.
A REIT can give its shareholders dividends ranging between 2% and 8% annualized yields. Furthermore, REITs are obligated by law to distribute at least 90% of their profits to their shareholders.
On paper, that sounds great as it can create a steady income stream. Combine that with the historically great performance in equity appreciation of over 12% for REITs, and it’s no wonder that some investors see piles of money ahead.
That said, syndication, as mentioned above, has multiple revenue streams. Particularly for sponsors, they can make money in acquisition and management fees, ownership, and various performance bonuses, including profits from capital events such as sales.
In terms of returns, most syndications also set more significant financial goals. The average annualized return on a syndicated investment in the real estate sector can exceed 20% – when factoring in both cash flow and appreciation.
REITs don’t have the potential to double an investor’s money in five years. While traditionally great for generating income through dividends, REIT stocks grow slower, albeit consistently.
Starting a REIT vs. a Real Estate Syndication
As a sponsor, you can start an investment group with no money down and work your way into a profit through sweat equity. Once a deal term reaches maturity, you can sell the property and move on to another deal.
The same can’t be said about starting a REIT. The IRS has strict criteria that you have to meet, starting with a minimum of $100 million in already owned properties and a payout structure that can see you distribute over 90% of the profits to your investors.
And that’s just to satisfy the requirements of a private, non-listed REIT.
The regulations differ from those of syndicated offerings, and the effort required to find enough investors and enough income-producing properties might not be worth the trouble.
Besides, REITs hit the big payday after they go public, which in and of itself is an arduous and expensive process.
Making the Smart Call
If you’re a billionaire, you can go ahead and hire a few advisors and start a REIT in no time. But if you’re reading this article, that’s not your financial position. You probably have limited to no capital but a plan to make money through real estate investments.
In that case, real estate syndication is arguably your best bet. Although it can be difficult to find investors, you have a massive opportunity to make a profit by providing sweat equity and handling the management aspect of the investment. In contrast, accredited investors or sophisticated investors fund your project and help you build a track record that will open up new doors and deals.
Tilden Moschetti, Esq., is a highly sought-after syndication attorney with nearly two decades of experience. His clientele ranges from real estate developers and startups to established businesses and private equity funds. Tilden’s expertise in syndication law comes not only from his knowledge of syndication and securities law but from real, hands-on experience as an active syndicator himself in every real estate product type and nearly all markets in the US. His knowledge and experience set him apart and established him as the Reg D legal services leader.