Real estate syndication is increasingly popular. I have heard everything from “everyone is in this space” to “this is the perfect way to go for my career.” With the real estate market being highly attractive to investors from all walks of life (for many reasons), syndication presents itself as one of the best ways to enter the market, especially for those with less capital, looking for diversification, or those who just want to add this as an asset class to their portfolio.
More than 120,000 investors participated on record in syndication deals in 2020, and that number is expected to rise. The average deal size was in the neighborhood of $3 million, which, incidentally, is my preferred area. I do deals typically between $3 – $10 million.
Regarding preferred returns, they average out at 8%, although the percentage can go up to 10% in many cases, or even higher for those riskier sorts of investments like development deals. While passive investors or capital investors were responsible for up to 90% of the initial investment, sponsors land within the 5% to 20% range, but even that is flexible.
It’s worth noting that the S&P 500 Index’s return over the past two decades hovers around 8.5%. Commercial real estate outperformed the stock market over the same period with an average return of 10.6%.
In this sector, only real estate syndication and real estate investment trusts (REITS) did better at 11.8%. However, REITS don’t offer investors the same level of control over their investments or provide great returns on short-term investments, plus there is, we have found in our research, a lot of added waste for wall street professionals.
That’s why real estate syndication is garnering so much attention.
What’s the difference between passive investors and sponsors? The following article will explain these matters and much more to give you a clearer understanding of this type of property investment deal.
Real Estate Syndication in a Nutshell
In the simplest of terms, real estate investors engage in syndication when they combine their financial assets and intellectual resources to invest in large income-producing properties. An example would be a multifamily property syndication. Typically, this involves projects that no one or two investors could manage, building in enough equity on their own.
For a long time, real estate syndication was a form of investment reserved only for the industry’s wealthiest, most connected, and successful individuals. Connections and capital would open many doors.
However, in recent times, real estate syndication has borrowed some principles from crowdfunding and is now a more mainstream avenue for smaller investors to become multi-property owners and diversify their portfolios.
Of course, this is an oversimplification of a complex topic (see our Real Estate Syndication FAQs which goes into more details). There’s more to know before taking part in this type of venture.
Real Estate Syndication – How It Works
Syndication represents a transaction between groups of investors and a sponsor. The sponsor, or real estate syndicator, usually handles the bulk of the work. If you’d like to become a sponsor, it would involve tasks like scouting the property, finding interested investors, and raising funds.
Managing, negotiating, and doing the deal also fall under the sponsor’s purview. Once the deal closes, the sponsor then takes on the day-to-day operations involving the property. Through this work, a sponsor gains sweat equity, as the investors contribute with financial equity.
However, most real estate syndication deals provide for the sweat equity portion to account for 5% to 20%, while the investors supplement the with capital.
In theory, the best deals see sponsors getting as much skin in the game as they can because it gives them additional motivation. Thus, investors do want to find a sponsor who contributes sweat equity and it is advisable to go into syndication as a sponsor looking to invest money into your own projects. Strongly recommended, but not 100% required…
The Legal Structure
According to the SEC, doing deals with multiple passive investors requires the parties involved to form a syndication – hence the term real estate syndication.
To make things easier and safer for everyone involved, most real estate syndication companies are structured as Limited Liability Companies or, albeit rarely, Limited Partnerships. Inside these structures, the sponsor acts as the manager and general partner, while other investors have a limited partnership capacity – passive members.
Due to the nature of these legal structures, it’s essential to create proper documentation including private placement memorandums, operating agreements, and subscription agreements.
- LLC Operating Agreement
- LP Partnership Agreement
The documents are necessary for agreeing on voting rights, rights to distribution, as well as a sponsor’s rights to particular fees associated with managing this kind of investment.
In many ways, a real estate syndication structure is similar to that of private equity funds, venture capital funds, and even some forms found in the venture debt sector. Establishing a legal entity protects investors and their syndicators from each other, governing bodies, and other financial institutions.
The Role of the Sponsor in Real Estate Syndication
Although many parties can become involved in a real estate syndication transaction, passive investors have little to do except put up the necessary capital. Most of the work falls on the sponsor.
Here are some of the things a sponsor must do, usually with the help of a specialized attorney, such as my firm the Moschetti Law Group, starting with the first important document – the PPM.
A Regulation D private placement memorandum (PPM) is also known as a disclosure or an offering memorandum document. They all mean the same thing, and while similar in some regards, it’s different from the prospectus issued by companies during a private placement offering.
The PPM document essentially outlines all the essential information regarding an investment decision. They tend to be lengthy yet are extremely vital to paint a clear picture of the deal on the table.
When people ask what is PPM, they want to know the structure or how this kind of document should look when composed the right way. So, let’s talk structure.
Private Placement Memorandum Structure
The PPM does 3 things:
- It explains in non-legalese language what the operating agreement says.
- It provides the disclosures, disclaimers, and warnings to the investors so they know what they are getting into.
- Well, this is actually the secret sauce. I’ll give you a hint: we call our PPM preparation for real estate syndicators a Persuasive PPM™ for a reason…
As is the case with all official documents, the PPM should start with an introduction. It doesn’t have to be lengthy, but it should provide a general overview of the company and the syndication. Real estate is a complex sector. Thus, a summary can help some investors understand the value of the proposed deal in front of them.
After the introductory section, the investment memorandum should contain a detailed summary of the investment – it can include property details and other crucial highlights in the offering.
From there, it’s generally a good idea to go over the risk factors in a separate section. Thorough PPM documents contain general real estate investment risks, as reminders, along with risks and potential drawbacks related to that specific deal.
Common problem areas include the state of the property, tenant issues, market concerns, potential economic development, etc.
Then, the PPM should clearly state who the sponsor is. The document offers financial information, a track record, as well as all the people involved in putting the deal together and managing the property moving forward.
Another section of a PPM investment document would outline the use of proceeds. It explains to investors how their capital will be used in the following deal – renovations, down payments, etc.
It’s also a good idea to present a clear overview of the fees associated with a private placement offering. This section typically informs investors of loan, acquisition, and asset management fees, among others.
Another important aspect of a PPM is the syndication terms. This section discusses the minimum investment, a projected return on investment, as well as the length of the investment. The same section can propose the equity split between investors and settle the profit split structure.
Depending on the type of real estate deal, other sections can be added to a PPM document to cover potential tax regulations, conflicts of interest, securities, and so on. However, it’s important to discuss the investor’s suitability at one point or another. Interested parties need to know that anyone can participate or that the deal is only available to accredited investors.
Drafting this documentation is one of the most important aspects of being a sponsor. It not only allows you to select your investors but to also answer most if not all of their questions. As for passive investors, it’s in their best interest to fully review these papers to determine exactly what they would agree to, if they decide to do a deal.
Splitting the Profits
Before going all-in on a real estate syndication venture, it’s essential to understand how all parties involved split the profits. Let’s assume you were to invest $50,000 in a property that yields a 10% preferred return. That would net you $5,000 every year, once the property generates enough money to make payouts available.
Everyone gets their preferred return before further splits are done. Any money that remains gets distributed between the investors and the sponsor. Granted, this depends on the agreed-upon profit structure of the syndication.
Assuming a typical 70/30 split, investors would divide an additional 70% of the remaining profits amongst themselves, while the sponsor would get 30% after the preferred return.
It’s also worth noting that sponsors usually net an upfront profit. It’s an acquisition fee for finding the property, putting together the deal, and closing. Generally, it doesn’t exceed 2% and won’t fall under .5%. The size of the transaction may affect the percentage.
Of course, because passive investors put up the bulk of the capital, they have priority on receiving preferred returns at the rate stipulated in the contract.
How These Deals Make Money
One of the things that any non-accredited investor or would-be sponsor wants to know is how real estate syndication generates money. It usually comes from two primary sources:
- Rental income
These are the two staples of revenue generation for the sponsor and their passive partners.
With syndication, real estate rental income gets divided between the investors. It can happen monthly or quarterly, depending on the terms of the agreement. But since properties often appreciate over time, the syndication can gradually increase the rent.
Appreciation also allows investors to net a higher return if the property gets sold for a considerable profit.
What’s interesting about this transaction is that a syndication investment matures. In some cases, this can happen within 12 months. But in other instances, they can last up to 10 years.
Why Most People Turn to Private Placements
The answer depends on which side of the fence you’re on when going into a syndication transaction. Sponsors generally do this because they couldn’t otherwise engage in particular deals due to a lack of equity capital. Others do it because it’s what they’re great at and enjoy the complexities of the process.
When it comes to investors, they too may do it for different reasons. For example, some investors are juggling too many balls at the same time. Therefore, they lack the time and will to find their own deals and underwrite potentially thousands of properties until they find the perfect asset.
Furthermore, syndication facilitates deal flow, with many companies and private sponsors ready to pair investors with their ideal real estate assets.
Of course, another type of investor is the one who’s just getting into real estate and knows very little of the industry. They have the capital but lack the knowledge and skillset to personally buy and manage one or more properties. Thus, syndication helps them find good investment opportunities and takes care of the managerial aspect of property assets.
Things That Can Set Sponsors / Syndicators Apart
Like any other sector of real estate, syndication presents some challenges, particularly for sponsors. It’s a highly competitive market, and attracting investors isn’t as easy as some people believe.
To succeed in real estate private equity, a syndicator should be able to offer attractive properties in great neighborhoods. The properties should have great potential as far as rental income goes while offering an appreciation upside.
Another alternative is to find the best fixer-uppers on the market that can go from under-market rents to high-yielding properties after low-cost renovations.
Most accredited investors like to see a rate of return of 30% or even higher over a period of five years. Naturally, this isn’t always an option. But the higher the return, the better the deal’s chances of going through.
In terms of an annualized return, most investors settle for anywhere between 8% to 10%. To further make the offer more appealing, sponsors can focus on finding properties that can appreciate at least 20% in five years.
One last thing to mention here is expertise. Investors can figure out if a sponsor knows their craft or not, depending on how they present the offer. Therefore, it’s vital to become an expert on doing your due diligence, analyze the market, and put together profitable syndication transactions for everyone involved.
Pros and Cons of Real Estate Syndication
When all is said and done, syndication has more advantages than disadvantages, as long as great sponsors partner up with savvy investors.
- Increased Buying Power
One investor with $400,000 of buying power may not be able to do much. However, if five or ten investors show up with $400,000 each, it’s a different story.
The combined buying power can open up the potential investment pool. It can present investors and sponsors with new opportunities, potentially even higher-yielding opportunities.
That happens because larger assets are often more liquid compared to small properties. On top of that, they hold their value in time and can appreciate faster.
- Tax Benefits
Like all forms of real estate investment, syndication offers some considerable tax benefits. Forced appreciation quickly comes to mind, which helps investors squeeze even more profits out of their investments. Other things such as write-offs are also on the table, which makes syndicated properties attractive assets.
- Passive Investing
Apart from the sponsor, all other members of a syndication are silent or passive partners. That means syndications are, by definition, passive investment opportunities in which the investors can simply sit back and wait for their profits.
- Great Cash Flow
Provided that the syndicator puts together a good deal, syndicated investments have amazing cash flow potential and scalability.
With that in mind, there are some risks involved. Without enough research and a good review of the documentation, investors can enter unfavorable agreements.
Despite typically being liquid, the real estate market goes through cycles. Sometimes the market becomes illiquid, especially when talking about larger properties. Thus, a commercial real estate syndication can go through slumps.
But when has the real estate sector not presented some form of risk?
True Passive Investment Deals
If you’re passionate about real estate, then syndication could be your best option to get into the market. It has the lowest entry barrier for gaining equity, whether you’re an investor or a syndicator.
Pooling resources together enables a small-time investor to get a taste of how the 1% enjoy the consistent deal flow and build massive fortunes without much legwork. As a sponsor, you can earn tons of experience and build sweat equity while sticking to your passion.
Remember that the real estate industry is responsible for some of the world’s largest fortunes all over the globe. It’s incredibly lucrative, arguably more stable, and hugely exciting once you venture deep enough into this world.
Hopefully, your mind is now open to far more wealth-building possibilities with this newfound knowledge of real estate syndication.