Investing in property comes in many forms. Investors can explore a broad range of opportunities and asset types in various real estate industry sectors. Some require more significant capital, while other options (such as multifamily syndication) are available to the general public.
One of the problems with these investments is figuring out the goals. Is generating cash flow the primary goal? If so, certain types of commercial and residential assets can fit the bill.
However, when talking about flipping properties, the commercial angle might not be the way to go. Then you also have to think of potential land grabs for future development. Many investors today choose to go a different route.
Everything mentioned so far typically involves an active investment. These assets need maintenance, management, and oversight. But some investors choose to take a passive approach. They prefer buying equity in a property and letting someone else manage their investment by handling the workload.
When these deals occur, they often involve income-generating properties such as any unit you can rent out and create a positive cash flow to split the profits between investors.
And this is where sponsors come in. Sponsors or real estate syndicators can create real estate syndications or legal partnerships where multiple investors come together on the same deal.
One of the most attractive projects of this kind to any passive investor with no ambitions of being a landlord is called multifamily syndication. This article will focus on what it is, how it’s structured, and some of the benefits, risks, and limitations of opting for this type of investment partnership.
What is Multifamily Real Estate Syndication?
Multifamily real estate syndication is when a sponsor or general partner locates an income-generating multifamily property and raises money from passive investors to make the down payment to close the deal or buy the entire building.
The sponsor is tasked with managing the investment and ensuring it can generate substantial cash flow to pay investors. One thing that differentiates multifamily syndication from other deal types is that this one targets multifamily housing projects.
Usually, most investors and syndicators look at commercial real estate syndication and see retail properties, office buildings, and other similar property assets. However, multifamily real estate can also fall in the same category as senior housing or student housing properties.
In using the term multifamily, one can differentiate the asset class from the typical townhouses, family homes, and other small residential households.
Granted, multifamily syndication can be a small-scale investment where partners pool their resources together to buy a duplex. Units with two households within the same building, sharing plumbing, electrical, HVAC systems, and shared walls, are classified as multifamily real estate.
When starting in real estate syndication, sponsors may opt to get a couple of deals under their belt with smaller properties to familiarize themselves with the process and build a reputation. It’s also common for investors to buy up to a four-family property to occupy one living space and rent out the remaining units.
That said, the topic of multifamily real estate syndication is more layered than that. Large apartment complexes with 200 or more units, spanning multiple buildings, also fall within this syndication structure.
Some deals can be so ambitious that it would take more than one syndicator to manage the property. In these situations, multiple investors may sign with a real estate syndication company with sufficient manpower to oversee the daily operations and meet the desired return targets.
Understanding Real Estate Asset Classes
One of the most common things sponsors and investors should know about multifamily syndication deals in the different asset classes involved.
Think of an asset class as a particular group of investments with similar traits and marketplace behavior. In terms of equities, the three dominant asset classes are stocks, money markets, and bonds. But commodities and real estate also qualify, although they’re often referred to as alternative investments.
So, when it comes to commercial real estate syndication, it’s helpful to distinguish between different asset classes, depending on the properties involved. In a way, this doesn’t make much sense since real estate is considered an asset class.
While the terminology is used interchangeably, it’s worth noting that the correct designation would be property class instead of asset class.
As such, before putting a deal together, a sponsor will scout Classes A, B, and C properties by looking at a mix of demographic, geographic, and physical characteristics. The reason for dividing buildings into categories is to have each group representing a specific risk profile and potential return.
With that in mind, let’s talk about the three property classes in multifamily real estate syndication.
The Three Multifamily Real Estate Subclasses
Before detailing each category, this is what you should know. Properties in excellent standing, arguably expensive, and residing in desirable locations fall under Class A. Class B properties are next and are categorized by requiring renovation to reach a Class A status. Then, you have your Class C properties that offer the cheapest commercial real estate deals and more risk.
Class A Multifamily Syndication Properties
A Class A multifamily syndication deal goes after the safest investments. You’ll find these buildings located in primary markets and generally areas enjoying a stable economy. Typically, Class A properties are near major employers, hospitals, cultural centers, and universities.
They provide unrestricted access to public transportation hubs and highways. In short, they’re always in places where people usually want to live and rarely move out. Thus, there’s great potential for sustained cash flow, rising rents, and getting great returns on long-term deals.
Accredited investors might also prefer a Class A investment asset due to being finished and ready to move in without further renovation. This means that passive investors wouldn’t necessarily have to wait for their preferred return to accrue in a couple of years once the deal closes. They can reap the rewards much sooner.
It’s important to understand that Class A buildings don’t have to be brand-new to fall into this category. Recent renovations, high-end finishes, and amenities, as well as other factors, define the risk profile and return potential rather than just the building’s age.
The defining characteristic of Class A real estate assets is the ability to command high rents from tenants. That, combined with the increased demand in those areas, can generate a strong cash flow.
Apart from the usual accredited investors, others could be interested in these multifamily syndications, including foreign investors or even institutional investors. Hence, it isn’t easy to close this kind of deal without raising money from multiple investors and increasing the buying power of the partnership.
Class B Multifamily Syndication Properties
A step down from Class A buildings, Class B multifamily properties are often older buildings that lack some amenities. You won’t find fitness centers, covered parking, pools, and other high-end facilities offered by many Class A properties.
As a result, these real estate syndication deals can’t expect to make as much money from rent. However, there’s also an upside. More affordable rents and decent homes still attract stable, long-term tenants. Vacancy rates are still lower than in Class C buildings, so they are desirable entry to midrange investments.
One thing to note is that the lower investment cost might not always compensate for potentially higher maintenance costs. Light renovation could be required to improve the living standards in Class B buildings and maximize rental income.
Therefore, syndication general partners, or sponsors, have a bit more work to do while managing Class B properties.
Class C Multifamily Syndication Properties
Class C multifamily buildings have tons of potential yet come with the highest risk profile. That’s not to say that with a solid investment strategy, a syndication partnership can’t expect great results while enjoying a lower entry barrier.
Let’s talk risk.
Part of the problem is that buildings in the Class C category are often at least 20 years old. Therefore, they could require substantial renovations inside and outside. Crumbling facades are common, as are other signs of physical deterioration.
Amenities aren’t often part of the deal, and neither are modern features. Investors can expect to see most of the original appliances, plumbing, and even wiring. Given today’s power consumption standards for the average household, redoing the wiring could be a top priority for the sponsor to handle.
In terms of location, Class C homes are found in lower-income neighborhoods. While that’s not always bad, the less desirable locations could attract more unreliable tenants or short-term and seasonal renters. This could have a negative effect on the cash flow and profits.
One can’t dismiss that lower-income neighborhoods typically have higher crime rates and lack a solid infrastructure with top-tier schools, quality employers, and other amenities.
It’s worth adding that not all less economically developed locations have short or long-term plans to boost the economy. A Class C multifamily property may never reach Class A or B status due to the lack of interest in raising the community’s quality of life standards.
Increased vacancies are to be expected, even though Class C homes demand low rent. Most tenants don’t have stable financial situations, and that might not change for a while.
But this risk profile presents an upside, too, particularly in the form of pricing. Class C multifamily buildings are almost always underpriced. Although they demand a higher upfront cost to raise the living standards, the overall investment should still come cheaper than buying equity in a Class A property.
With that in mind, Class C properties are defined by two things – having the lowest investment costs and requiring more planning and strategizing than any other multifamily building category. While hard-earned, when done right, this type of property can yield the highest return on investment in a real estate syndication project.
Without a sponsor who knows what they’re doing, this investment can be a bust, and the accredited investors could lose their money. It’s best to exercise even more due diligence when scouting properties within this category and going for the big profits play.
How Property Classification Works
Now that you better understand each property class, it’s essential to learn more about the factors that affect classification, starting with one of the biggest drivers – location.
Class A multifamily units are well-located and provide easy access to hospitals, educational institutions, good employers, restaurants, retail centers, and other desirable amenities. The location factor also analyzes the schooling situation and crime rates.
Looking at the latter is crucial as most Class A properties are in high-density urban areas. Interestingly enough, while crime might be low, the school districts might not be top-quality. Suburban schooling alternatives tend to win in a direct comparison. But it’s not that difficult to find a good balance with proper market research.
Location classifies specific properties as either Class B or C if they’re in less desirable districts. The higher the crime rate and the poorer the infrastructure, the lower down the ladder the property goes until it reaches Class C.
That said, location is just one driving factor. Other considerations play a role in determining where a property fits. A Class B or even C property can be in an excellent area yet lacks modern features, amenities, or structural conditions to qualify as a Class A building demanding high rent.
Often the condition of a property has a heavier weighting on its classification. High-end finishes and new renovations go towards a Class A stamp of approval. On the other hand, old buildings that need structural and cosmetic repairs could fall into either of the other two categories, depending on how much investment is required to improve the quality of life and safety.
As previously mentioned, a building’s age won’t be the only determining classification factor, but it is one of them. Age is often tied to the condition of the building.
Of course, provided a building has been adequately renovated, it could go from Class C to Class A should it feature better amenities, quality finishes, and tick other factors off this list.
The broad range of amenities available, or lack thereof, in some properties can influence the classification. For example, people are attracted to multifamily housing options that provide a concierge service or underground parking.
They may appreciate an outdoor pool or a pet daycare center and fitness rooms. Generally speaking, larger apartment buildings or building complexes have sufficient space to fit more desirable amenities.
Unfortunately, that doesn’t guarantee that those amenities will be on-site.
Accredited investors and syndicators are very interested in the occupancy or vacancy rate of any investment property. A high vacancy rate is indicative of inadequate cash flow, which could lead to unappealing profit projections.
Occupancy obviously increases from Class C to A, with Class B falling somewhere in the middle. The majority of people prefer to pay a higher rent in a Class A multifamily unit because it offers so much more than a roof over their heads.
Those attracted to Class C homes, for instance, tend to be renters with low credit scores and unstable salaries. Thus, the vacancy rate can fluctuate wildly without a reliable management strategy in place to increase occupancy.
It’s worth pointing out that there can be some rare exceptions for Class B and C properties. There is a trend out there that sees high-income individuals and families shift their attention to more cost-effective housing options while saving money to become homeowners. Finding some of these tenants might do a lot to stabilize the cash flow and perhaps even make the property more attractive to other like-minded individuals.
Risks per Category
Starting with Class C, we usually see two high-risk factors. First, we have the cost of repairs and potentially increased expenses associated with management over the course of the deal term.
Furthermore, most tenants’ lack of employment stability directly affects the cash flow and can make it challenging to earn substantial profits.
Note that Class C properties are sometimes close to being functionally obsolete if they don’t undergo renovations. Of course, the quality of the tenant pool rarely gets investors’ hopes high. It’s not uncommon to have to plan for defaulted rents when making projections.
That’s probably why most sponsors push towards refurbishing these buildings and bringing them up to Class B or even Class A status. It can help attract more reliable tenants and command a higher rate of return from rent profits.
Although Class B properties may also need some cosmetic help, that’s not the most significant risk factor. Perhaps the biggest issue comes from the heavy competition in this space.
Consider the fact that as newer Class A properties emerge, older ones in this category can get downgraded to a Class B classification. Therefore, this raises the bar over time and creates fierce competition in the multifamily housing market.
On top of that, investors could lack the capital to maintain the living standards or upgrade them over time.
Regarding Class A multifamily buildings, nothing threatens an investment more than oversupply. As you probably know, the property market can get stronger during certain cycles. When that happens, land prices and construction costs increase. But this can also demand underwriting properties increasing rents and reducing the overall yield.
Some developers might become obligated to focus on raising Class A apartment complexes to keep their companies afloat.
Boom market cycles carry some risk, too, as high-income tenants might be in a better position to make the switch to homeownership, thus decreasing the occupancy rate of real estate syndication, owned and managed, multifamily units.
Raising Capital From Investors for Real Estate
Going into a multifamily syndication deal as a sponsor requires knowing slightly more than the property classes, risk profiles, and potential upsides. A real estate syndicate is an established legal entity that has to follow specific regulations, as the process is similar to that of issuing securities. It pays to have a real estate syndication attorney, such as Moschetti Law Group, who is experienced in the law and the business of real estate syndication.
Therefore, it’s essential to be aware of the rules that govern these investments, as imposed by the SEC.
Reg D 506 Options for Real Estate Syndication
Small companies and investors can raise capital for multifamily syndication deals without registering contributions as securities when raising private placement money through Regulation D and its various rules.
The deal’s sponsor decides under which rule of Reg D to register under 506(b) or 506(c) and handle the proper form D filing. (There is also Reg D Rule 504, but I find that most investors choose 506(b) or 506(c) when choosing from the SEC’s Alphabet Soup.)
With a Reg D offering, the created syndicates can have many advantages in raising capital and who they can bring on board.
That said, the SEC rule 506 variations each deserve some consideration to figure out if they align themselves with the sponsor and investors’ goals.
Regulation Rule 506(b) Real Estate Syndication
Under this regulation, syndicators can get money from an unlimited number of accredited investors. There’s no cap on the money you can raise or a specific timeframe associated with the process.
By filing for a Reg D 506, you can join forces with 35 sophisticated investors who may not have the capital to meet the accredited investor status but have experience in real estate or good advisors.
Regulation D Rule 506(c) Real Estate Syndication
Similar to the previous rule, investors can raise unlimited capital in their syndication deals. Accredited investors are the only ones allowed, and the sponsor is obligated to verify them as per the SEC’s mandate.
However, what makes filing under the Reg D 506(c) even more appealing is that the established syndicate can advertise its Regulation D offering. In doing so, sponsors can also bring people they don’t know on board, opening up more opportunities to raise capital and go after even larger projects.
Regulation A Real Estate Syndication
Regulation A offerings have been around since 2012 when the Reg A offering was introduced into the Jobs Act. It enables investors or real estate syndication companies to get up to $50 million in money from the public.
Of course, investors still have to get a permit from the SEC. But it’s not your typical complete registration that could, for example, allow the company to be listed on the stock market.
However, the permit allows advertising and raising capital from accredited investors as well as non-accredited ones. As a sponsor, you can bring anyone that fits your ideal investor profile on board. Unfortunately, issuing this type of permit can sometimes take up to five months.
Regulation CF for Real Estate Syndication
The final option is Regulation CF. This regulation has changed in recent years to now allow up to $10M to be raised (previously it was just $1M and so unworkable for most projects). It does allow nonaccredited investors and advertising, but there is a huge catch. All transactions most take place within a registered portal, which, in my experience, tends to keep most real estate syndicators out of the running as deal time is too short to get them properly vetted by these portals.
The Strongest Cash Flow Generator for Real Estate Syndication?
As long as people need a roof over their heads, there will be a high demand for housing, even in lower-quality neighborhoods. But there’s a caveat with the usual investments in one to four-unit properties.
They’re not always cheap, nor do they generate high enough profits to attract multiple investors. When you’re talking about multifamily syndication, you’re talking about dozens if not hundreds of homes.
Although expensive, these large properties can generate substantial profits when properly managed, renovated when needed, and marketed to the right tenants. It’s the sponsor’s duty to locate prime multifamily real estate either ready to rent or ideal for a renovation project to bring the property up a class or two and get a higher return on the investment.
Create a detailed risk profile on any building that registers with your vision and figure out how to make it profitable enough that investors would jump at the opportunity. Depending on who you want going in on the deal with you, file with the SEC under the most favorable rule or regulation.
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.