Real estate syndication refers to the practice of combining multiple real estate investors’ assets to carry out a large commercial transaction. In this scenario, passive investors provide the capital in exchange for ownership shares. Meanwhile, real estate syndicators, known as general partners, handle the negotiations and paperwork.
Equity vs. Fees
Real estate syndicators make a living from collecting their portion of equity and fees, while passive investors only receive equity. In general terms, equity – often called shareholders’ equity – refers to all the money that a company’s shareholders would receive back if all company’s assets were liquidated and debts paid off. In other words, it’s the amount shareholders invest in a company minus any liabilities.
In real estate, equity is the amount a shareholder would receive after paying off any debts and selling the property. Therefore, it’s the difference between a property’s market value and money owed to lenders. For instance, if a property’s market value is $300,000 and its owner paid $200,000 in the mortgage, their equity is $100,000. But that’s a simple explanation of a single owner’s example.
In the case of real estate syndication, each of the several investors may own different shares, depending on the investment amount. Let’s assume a property initially costs $500,000. One investor provides a $50,000 capital, the second one $100,000, and the third one $350,000. The first investor owns 10% of the property’s shares, the second 20%, and the third 70%.
After the property’s sale, the funds will be distributed based on the portion of owned shares. So, if the property is sold for $1,000,000, the first investor would get $100,000, the second $200,000, and the third $700,000, assuming that no liability is involved.
But even though the shareholders received double the amount from the property sale, we should consider the initial investment. So, if the first investor funded $50,000 and received $100,000 after the sale, their equity in the property would be $50,000.
Unlike shares, equity isn’t constant. It may fluctuate based on the property’s market value, liabilities, added fees, and other factors. Sometimes, investors lose their equity if a property’s value rapidly falls.
Real estate syndicators or general partners usually own 5-30% of a property’s shares, but this figure may vary. Therefore, they will typically have some equity in the deal. However, they also charge passive investors extra fees, which impact the equity of each deal participant.
Let’s take our previous example with a $500,000 property and three investors and assume that the first one is also the syndicator. Apart from owning property shares, he also charges other investors an acquisition fee of 2%, or $10,000. In this case, each of the two passive investors would pay an extra $10,000 in fees. And since fees are a liability, they would also affect the investor equity at the point of the property sale.
Without the fee, the second investor would own $100,000 in equity, and the third – $350,000. However, if apart from the initial investment, they also paid $10,000 in fees each, their equity would equal $90,000 and $340,000, respectively. As for the general partner, their equity would rise from $50,000 to $70,000, as they’ve received $20,000 extra in acquisition fees.
Passive investors should understand that their property equity is closely tied to the amount they pay general partners in fees. The higher the fees, the lower is passive investors’ equity. Therefore, evaluating the contract conditions and choosing the most beneficial option is vital for a successful syndication deal.
For example, if the general partner provides a 15% investment return, their equity is 10%, but if they manage to deliver a 20% return, their equity raises to 15%. In other cases, the syndicate obliges to first repay a specified percentage of revenue to the investors, and the remaining amount is split between all parties.
Asset Management Fee
Now that you know why real estate syndication fees are important and how they affect your equity, we can review them in detail. One of the fees involved in any syndication deal is the asset management fee. As the name suggests, it’s meant to reimburse all general partner asset operations and management expenses throughout the deal.
Real estate syndication deals require continuous management, including bookkeeping, coordination, and communication. Without proper management, the plan execution would be impossible. Real estate syndicators typically charge 1-2% of the gross property revenue for this vital work. The fee is paid either monthly or annually, depending on the deal conditions.
Let’s look at an example – a passive investor funds $500,000 in capital for the purchase of a $5,000,000 apartment complex. The effective monthly renting income from the entire complex is $25,000. The passive investor owns 10% of the shares and, therefore, $2,500 of the monthly income. But the syndication company charges 2% of the revenue, so the investor must pay $500 monthly as an asset management fee. The asset management fee is calculated based on the investor’s share rather than the entire property revenue.
Sometimes, asset management fees are calculated based on the investor’s equity percentage rather than on the property revenue. In this case, the asset management fee typically ranges from 1% to 2% of all contributed capital. For example, if an investor funds $100,000 of a $500,000 property, they will pay $1,000-$2,000 in asset management fees.
An important point to note is that these two asset management fee calculation methods can lead to very different amounts, benefiting one party more than the other. The real estate syndicators and investors should evaluate which method is better for them and come to an agreement. Let’s look at another example. A property costs $2,500,000, and one of the investors contributes $500,000 in capital or 20%. If they had to pay a one-time 2% asset management fee, it would equal $10,000.
Now, let’s assume that this property earns $50,000 monthly, and the asset management fee is 2% of the revenue or $200 monthly. If the investor owns shares of the property for five years, they will pay $12,000 in asset management fees as opposed to $10,000 if the fee was calculated based on the contributed capital. However, if they plan to sell their property shares in three years, they will only pay $7,200 in asset management fees.
Property Management Fee
Apart from assets, the real estate syndicators must also manage the property. Asset and property management fees are calculated similarly but refer to different actions. The former relates to the management of a specific property. Meanwhile, the latter focuses on the bigger picture, referring to the management of all investor’s assets in the company.
Property management includes day-to-day property oversight, cleaning, maintenance, repairs, snow removal, rent collections, and any other operational and management expenses. General partners typically hire third parties to manage the property.
Construction or Development Fee
Construction or development fees are optional real estate syndication fees charged when a project involves ground-up or heavy redevelopment. For instance, the fees apply when the shareholders fund the building of a new apartment complex or when they purchase a historic building that requires façade renovation.
The construction or development fee is charged because the real estate syndicators must find third parties to carry out the project and constantly oversee it. Regardless of whether the syndication company does the project in-house or outsources it, the passive investors should expect to pay at least 3% of the capital expenditure budget. So, if a façade renovation of property costs $100,000, a passive investor may pay at least $3,000.
Asset Acquisition Fee
The asset acquisition fee is one of the most common real estate syndication fees charged for administrative expenses involved in managing the property acquisition. The general partner must facilitate the property acquisition and handle all the paperwork. Most real estate syndicators charge investors 1-2.5% of the acquisition cost. So, if a property costs $500,000 but the investor only funded $100,000 in the capital, they would have to pay $2,000 in a 2% acquisition fee.
Sometimes, syndicators are also licensed real estate brokers who charge a commission for real estate purchases. The broker commission typically ranges from 2% to 4%. While there’s no law prohibiting charging an acquisition fee along with commission, that’s widely considered double-dipping. Passive investors should be aware of general partners who collect both an acquisition fee and broker’s commission.
Asset Disposition Fee
One of the main real estate syndication company income sources is property appreciation. The term appreciation refers to an asset’s value increasing over time, as opposed to depreciation, which describes assets losing value. For example, most vehicles are depreciating assets, as their highest value is at the point of purchase, and it continuously declines. Real estate, however, is a different case. Real estate values may both decline and increase, depending on the property condition, market state, and other factors.
Naturally, both the syndicates and passive investors strive to maximize the return on investment over the years. Most real estate syndicators and investors hold their property shares for several years, waiting for the property’s value to rise, then sell them. At this point, they receive the appreciation income.
Like property acquisition, property disposition is carried out by the general partner rather than by passive investors themselves. Property sales always involve a lot of paperwork and marketing efforts. Syndicators charge a disposition fee of 1-2% of the sale price on average. As with the acquisition fee, the disposition fee is calculated based on a specific investor’s share portion.
There’s no universal asset holding period. Although most contracts include a proposed property holding period, it may change depending on the market state and other factors.
Investors rarely have multiple hundreds of dollars right out of pocket. Most passive investors get their capital from property loans issued by a bank or other financial institutions. If the investor finds the loan themselves, they don’t owe any fees to the real estate syndication company. But sometimes, the syndicators find financing for investors and handle all the paperwork. In this case, they charge a finance fee, typically ranging from 0.5% to 5%, depending on the loan amount, interest rate, and other factors.
As you know, loan interest rates tend to fluctuate, and predicting the change in rates is tricky. It isn’t rare for people to take loans with immense interest rates because of a bad market state and a poor credit score. If bank interest rates and the lender’s credit score improve over time, the lender may want to refinance their loan to save money in the long term.
Let’s assume an investor took a loan of $50,000 for six years with a 9% interest rate. They would have to pay nearly $15,000 in interest over the years. However, if they refinance the loan in the second year and reduce the interest rate to 5%, they will pay under $9,000 in interest over the years. In other words, people can take advantage of changes in interest rates. But this isn’t that simple.
Refinancing a personal mortgage loan is significantly easier than refinancing an investment property loan. Investors should collect a lot of documentation and own a specific equity portion of the property to refinance the loan. For this reason, refinancing is often carried out by real estate syndicators, who charge anywhere between 0.5% and 2% of the new loan amount for extra work.
Finding investors isn’t a simple task. It requires a strong marketing structure, and effective marketing is rarely free. Syndicators may develop an email marketing campaign, build a portfolio website, purchase advertisements online, and utilize other marketing efforts to reach new audiences. All these expenses must be compensated, so some syndicators charge investors marketing fees. Sometimes, the marketing expenses are indirectly reimbursed by slightly higher asset management and other fees.
Apart from marketing involved in finding investors, syndicators also act as marketers or hire third parties to sell the property. The fee may cover online advertising, meetings with potential buyers, professional property photoshoots, copywriting, communication, and much more. Property sale marketing fee may or may not be included in the asset disposition fee.
If an investor borrows money directly from the sponsor to buy the property, the syndicator may require a guarantee. Usually, the investor must put up some assets as collateral for the lender to claim if the borrower fails to pay off the debt.
Real estate syndication deals often involve preferred returns that may affect the fees and returns on investments. Preferred return is when a pre-defined amount of the revenue is paid out to the investors before the general partner.
Let’s assume investors provide $400,000 in capital and own 70% of shares in total, and the syndicator owns the remaining 30%. Without set preferred returns, the revenue is distributed according to the share proportion. So, if a property earns $20,000 a year, $14,000 will go to the investors, and $6,000 will go to the syndicator.
Now, assume that the preferred annual investment return is 5%. In this case, the first $20,000 earned that year is paid out to the investors, and the remaining revenue is split between all parties. If the property only earns $20,000 yearly, the syndicator gets nothing. And if the property earns $40,000, $20,000 is paid to the investors, and the remaining $20,000 is split 70/30, leaving the syndicator with $14,000 and the investors with $26,000.
This may sound good, but preferred returns only benefit investors when a project performs as expected. Now, imagine the property doesn’t bring as high revenue as planned. This could happen due to poor management, market change, or many other reasons. If the revenue is lower than the investor preferred return, the remaining return accrues to the following year.
In our last example, we’ll assume that the annual property revenue is only $10,000. The investors receive all the money, but there’s still a 2.5% preferred return not paid out. It will carry over to the next year, so the syndicators will have to repay 7.5% instead of 5% in preferred returns.
The problem is solved if the situation substantially improves, and the syndicator catches up to the normal preferred return rate. But if the situation doesn’t improve, the preferred return rate will continue to accrue each year until the syndicator realizes they will never catch up. In this scenario, the syndicator may try to sell the property to get at least some profit, which won’t benefit the investors.
The bottom line is that preferred returns may seem like a great deal for investors, but they create misalignment of interest. If syndication partners aren’t on the same page, someone will inevitably lose. And if the syndicator loses, the investors are usually next. Therefore, preferred returns are only beneficial in rare cases when all parties are sure of the project’s performance.
Syndicate Waterfall Types
The American distribution waterfall benefits the syndicator more than investors. In this scenario, the profits are distributed on a deal-to-deal basis rather than on the fund level. The syndicators start receiving revenue before the investors receive their capital return. The American waterfall structure may or may not involve preferred returns. If it doesn’t, it’s often called a straight split.
Unlike the American waterfall, the European waterfall model benefits the investors more than the syndicator. In this case, the profit distribution is applied on the fund level. The syndicator doesn’t get any revenue until all the investors receive their return of capital and preferred return rate. After the investor interests are met, the profits are split according to the shares.
For example, investors provide $600,000 in capital with a 4% preferred return or $24,000 annually. The syndicator will pay 100% of the available cash flow to the investors until they get back the $600,000 plus $24,000 for every year of capital returning. Only after the syndicator repays all the money can they start receiving their share of revenue while continuing to pay investors the preferred return portion.
The drawback of this model is that property doesn’t always provide expected returns. The syndicator may not receive profits for many years. If the situation lasts for too long, the accruing preferred returns may lead to major losses for all parties.
Straight split is the simplest type of asset distribution waterfall. In this scenario, each party gets a percentage of profits equal to the percentage of their investment. So, if the syndicator invested 30% and the investors 70%, all the property rental and sale profits will be split 30/70. No preferred return is involved in this waterfall structure, and the return of capital comes at the point of sale or refinancing the property.
No Fee Deal
Sometimes, the syndicator may not charge asset management or acquisition fees while handling all the expenses themselves. Furthermore, the syndicator obliges to pay the investors 100% of the cash flow until all their invested capital is returned. Once the capital is returned, any profits are split 50/50 between the syndicator and investors. Although in this scenario, investors are only receiving 50% of the equity, their interests align with the syndicator’s interests. The syndicator will strive to return investors the money as soon as possible to also start earning, and the investors can avoid management and asset acquisition fees.
Real Estate Syndication Benefits
The first and foremost benefit of investing in real estate syndication instead of the stock market and other investments is a below-average risk. Every investor knows not to put all their eggs in one basket. Asset diversification is vital for risk reduction. A good investment portfolio should contain investments in different asset classes with little to no correlation. If one invests all their money in a single project and it fails, they lose everything. But if they only hold 5% of their money in the project, they only lose a small portion of the capital.
Low risks don’t mean much without good returns. Thankfully, real estate syndication combines the best of both worlds, bringing investors above-average returns. One of the reasons for this is the real estate market’s low volatility and continuous appreciation. Another reason is the common interest of investors and sponsors.
Many real estate syndicators invest their own capital in the deals and, more often than not, the asset management fees depend on the returns of investment. General partners have a personal interest in maximizing the property’s profitability, so they will do their best to ensure good returns.
Access to Better Assets
One of the most apparent real estate syndication benefits is access to high-quality investments via pooled capital. Back in the day, the real estate market had a high entry threshold, which hindered many investors from participating. Nowadays, anyone with an annual income of over $200,000 can become part of real estate syndication.
This is beneficial not solely for building a good investment portfolio but also for investment returns. Cheap, low-quality property is unlikely to bring high returns and, sometimes, it may even be detrimental. On the other hand, high-quality real estate offers more opportunities for appreciation, benefiting every syndication participant.
For instance, an investor holding capital in a single-family rental property risks losing all revenue if the family moves out. In the case of a multi-family rental property, if a few tenants move out, investors will continue to receive revenue until they find new tenants.
Economy of Scale
Passive investors often don’t have sufficient capital and expertise to carry out large real estate deals independently. With syndication, the deal management is handled by industry professionals experienced in negotiation and knowing how the market works. Investors don’t have to handle paperwork, property management, marketing, or anything else – all they need to do is fund the capital and enjoy returns.
Inflation is among the biggest dangers to investors, making assets lose value over time. Real estate is an exception, as it only gains value despite inflation. Typically, the higher the inflation, the more property prices go up. Therefore, real estate syndication investments are an excellent inflation hedge.
Passive investors don’t have control over property management and performance, but they also aren’t liable for lawsuits and losses because there is no involvement in day-to-day operations. Meanwhile, investors can still vote on anything that reduces their rights or puts their investment return at risk.
Real Estate Syndication Risks
No investment is completely risk-free, so investors considering participating in real estate syndication should be aware of the risks. Let’s look at the potential downsides of real estate syndication.
Lack of Liquidity
Liquidity refers to how quickly an asset can be purchased or sold without significantly impacting its market price. Good examples of liquid investments are company stocks, cash, and gold. As you may have guessed, real estate is far from being a liquid asset. Investors should expect to acquire returns for at least a couple of years, and often over 10 years. There’s no way to call a syndicator after a few months of ownership and quickly sell your shares.
For this reason, investors should carefully evaluate the property potential and syndicators they’re dealing with. Although real estate syndication is accessible even for relatively inexperienced investors, a good understanding of the market is crucial to avoiding losses due to low liquidity.
Lack of Control
In addition to being tied to an asset for years, investors don’t have full control over it. The property’s performance depends on the operator’s efforts, who make all day-to-day decisions, from the choice of a security company to refinancing and sale. One may argue that it’s the main benefit of being a passive investor – you don’t have to do anything. Indeed, but this also means that investors must be extra careful when choosing syndicators.
Real estate syndication fees are a complex topic, so we’ve gathered some of the most common questions to help you understand it even better.
What’s the difference between property management fees and asset management fees?
In general terms, property management refers to the daily physical operations of a property and asset management to paperwork and financial operations. Property management fees are charged for property marketing, security, rent collection, cleaning, maintenance, repairs, renovations, and other daily operational processes. Meanwhile, asset management fees are charged for business plan creation, overseeing property financial aspects, capital expenditure reviews, annual tax return filing, and revenue distributions.
What’s the difference between the return of capital, return of investment, and preferred return?
Equity investors receive their invested capital as part of the waterfall distribution. In the American waterfall scenario, the return of capital is gradual. Sometimes, investors only return their capital at the point of sale. In the European waterfall model, investor capital return is the top priority, and all cash flow goes towards it until investors get all their funds back.
Preferred return refers to the percentage of initial investment investors should receive annually. Return of capital is part of the preferred return, but investors continue to receive preferred returns even after the investment capital is fully repaid.
Lastly, return of investment or ROI is the overall project profitability. ROI is calculated by dividing an investment’s profit by its overall cost. The result is expressed as a ratio and is used to compare a project’s profitability to other projects.
How do investors find the right real estate syndicator?
Choosing the right real estate syndicator is vital to maximizing profits and minimizing risks. A bad sponsor can fail even the most potentially beneficial deal. A real estate indicator should be experienced, professional, honest, and diligent – but how do you check that? Start by conducting research. Look for reviews, talk to people who previously worked with that syndicator, or read their portfolio.
Some beginner syndicators may be very talented, but experience is key to effective asset management. You want to know how long the syndicator has been in the industry, how many assets they’ve acquired, whether they are familiar with your location, and whether they’ve gone through an economic crisis. Compare their previous deal projections versus actual performance. Note that asking syndicators directly about their experience and track record is normal. There’s no need to hire a background check company, although fact-checking is beneficial.
Then, find out about the syndicator’s fees. As you already know, the contract conditions can significantly impact your returns on investment. The goal isn’t simply finding the most beneficial for your offer – otherwise, people would only invest in European waterfall deals with immense preferred returns. Instead, the goal is to align your and the syndicator’s interests. Often, the best syndicators charge the highest rates but also provide the highest return of investment.
How do you find investors as a syndicator?
Finding investors is no easier than finding a syndicator. The real estate market is big, and you should convince investors you’re their best bet. We won’t get into communication tips here, and instead, we’ll focus on the management. Choosing the right distribution waterfall structure is key to finding investors whose interests align with yours and maximize profits for everyone. The waterfall includes preferred returns and fees. Note that there’s no model that would fit every investor or syndicator.
A beginning syndicator without a strong portfolio could offer below-average management fees and above-average preferred returns to attract more people. Some investors would be willing to invest in a higher-risk deal with an inexperienced syndicator if they can get higher returns.
On the other hand, an experienced syndicator can charge above-average fees and not offer any preferred return even if they do their work effectively. If the property’s annual gross revenue is high enough, such a waterfall model may bring the investors more profit than one with high preferred returns and low fees. Therefore, a portfolio is essential to finding good investors with the most beneficial conditions for you.
Another point is to prioritize previous investors. If you’ve successfully worked with someone in the past and achieved your desired ROI, they will be more likely to agree on a deal again. Over time, you will build a wide lead web.
Get Professional Advice
Real estate syndication fees are a pivotal point of the investment return. The problem is that no waterfall distribution model fits all investors and syndicators equally well. Setting the right structure on your own is a complex task, even for experienced syndicators. At Moschetti Law, we’re happy to help you by reviewing your fee structure, comparing it with other syndicator fees, and giving sound advice. Get in touch today to create a successful syndication waterfall model to draw investors and maximize profitability.