- Be clear on your investment goals
Before you start investing in commercial real estate (CRE) it is important that you become clear about your financial goals. How does CRE fit into your financial portfolio?
While we are obviously fully committed to this asset class, we still believe that you should carefully understand how it can complement your other investments. One of the main reasons for investing in CRE is to diversify your portfolio and move some of your money from Wall Street to Main Street. There is also a low correlation between stocks and real estate which helps reduce volatility.
Review your portfolio and decide if a percentage of that money should be moved into CRE. There is advice that suggests allocating 5-10% to real estate. Other research has shown that high net-worth individuals have as much as 33% of their portfolio in real estate.
Also, keep in mind that your personal home should not be considered an investment in real estate.
- What is a Real Estate Syndication?
A real estate syndication is where a sponsor sources, underwrites, and get a property under contract. The sponsor then raises capital from investors to provide most of the equity in the property. The investors are passive limited partners (LPs) in the deal, relying on the active general partners (GPs) to operate the deal according to the business plan and financial projections.
The syndication is structured as a limited liability company or a limited partnership, with the rights and responsibilities set forth in the operating agreement. The investor signs a Private Placement Memorandum, Subscription Agreement, and Operating Agreement before wiring the money to the escrow company.
A syndication is usually a mid to long-term investment. The timeframe can be anywhere from 2-10 years, and is typically illiquid. So, the investor should be willing to invest for the long term.
The investor is paid a portion of the cash-flow and appreciation at the sale of the property. The cash-flow can be expressed as a straight split between the GP/LP. For example, 80/20 means 80% of the profits go to the LPs.
Some syndications have a preferred return, for example, 7%. In this case, the LPs are paid 7% of the invested capital annually before the GPs are paid anything from cash-flow.
The GPs will also typically get paid an acquisition fee of 1-3% of the property price for the up-front work securing the deal. There may also be an asset management fee charged by the GPs for the ongoing work of managing the investment. This fee can range from 2-5% and is paid to the GP before the profits are distributed to the investors.
- Benefits of passive investing vs. active investing
When presented with the idea of passive investing, many people’s initial thought is “I can do this myself.”
That is certainly possible and many investors have built sizeable portfolios with single-family and smaller multi-family properties. But, it takes a lot of education, time, work, and capital to be successful as an active investor. We built our portfolio by starting with a couple of 4-unit properties and then scaled to 11-units, 16-units, 38-units, etc. However, this was a difficult and time-consuming journey. We also learned along the way that the smaller properties are hard to manage and the cash-flow is not very predictable. If you own 4 units and one person moves out, you have a 25% vacancy.
If you own 200 units and one person moves out, you have .5% vacancy!
Of course, if you are willing to dedicate the time and effort to become an active investor, you can enjoy all the benefits of your work and don’t need to rely on anyone for your success.
On the other hand, if you have a successful career and prefer to leave the property investing to a professional then it may make sense to consider passive investing. You still get all the benefits of investing in large commercial real estate without the challenges associated with investing. Of course, you give up a share of the profits to the syndicator, but since these larger deals have better returns than smaller deals your earnings on syndications may be similar to investing actively.
- Tax benefits of investing in a syndication*
One of the major benefits of investing in a syndication is the tax benefits that come with the investment. A syndication is typically created as a partnership, which means all profits and losses are passed through to the partners you included.
All income is offset against expenses and one of the major expenses is depreciation. An apartment building can be depreciated over 27.5 years, which means that 3.6% of the building’s value can be taken as a deduction every year. That is a “paper” loss that is passed through to the investors on their annual partnership tax return (K1).
Many syndicators use a cost segregation study to accelerate the depreciation. For example, carpets and appliances have a shorter useful life, so they can be depreciated quicker. This means a larger “paper” loss in the first years of the syndication.
Therefore we often see a loss on the K1 in the first few years while the investor is enjoying quarterly cash flow.
Of course, the IRS doesn’t give anything away so the depreciation must be recaptured at the sale. However, depreciation recapture is taxed at only 25% while the rental income would have been taxed at regular income tax rates.
- How to connect with syndicators
Syndicators can let you know about their existence and deals in multiple ways. Depending on the type of investment offerings, they may be able to advertise directly to investors. This would include the large crowdfunding platforms that can be found on the Internet. These sites typically have several deals to invest in. However, due to the extra layer of management, you may see lower returns than connecting directly with an operator. There is also the challenge of not knowing the sponsor directly which requires a lot of trust in the crowdfunding platform to do proper due diligence.
An alternative is to connect directly with the syndicator or co-sponsor. You can meet these people by listening to real estate podcasts, going to multifamily seminars and events, or by asking for referrals from friends that already have invested in syndications.
- How to read an offering memorandum
The offering memorandum (OM) is the executive summary of the deal. It is usually a presentation deck that outlines the details about the property, market and sponsorship team. As a passive investor, it is important to study the OM and understand the business plan.
Here are some things to look for:
a). Is this a stabilized or value add deal? I.e., can the rent be increased by improving the property or is the team just going to operate the deal as is?
b). What are the projected returns? Returns can be broken into:
Split: Does the deal offer a preferred return or a straight GP/LP split?
Cash on Cash Return: The annual cash-flow based on the investment amount.
Average Annual Return: The average cash-flow return during the hold time.
Internal Rate of Return: The rate of return based on the net present value and a series of cash-flows.
Equity Multiplier: Total cash distributions received divided by the equity invested. Include the sales proceeds. If $100K was invested and $200K was received, that is a 2x equity multiplier.
c) What fees does the sponsor charge? Normally we should expect to see a 1-3% acquisition fee and a 2-5% asset management fee. There may also be a disposition fee of 1-2% of the sale price.
d). What is the projected hold time of the property?
- Evaluating the deal
After reviewing the OM, consider if the proposed deal meets your investment criteria. Are the returns in line with your goals? Does the hold time match your investment horizon?
How does the current deal compare to other opportunities in the market?
- Evaluating market
Another important consideration is to evaluate the market where the opportunity is located. What are the economic drivers? Is the population increasing, staying flat, or decreasing?
You will typically see a larger appreciation of properties in fast-growing markets. The cash-flow is often higher in stable areas. You will also see the prices in the so-called “hot” markets be higher while slower markets typically have lower prices.
So, the decision is often one of cash-flow now or appreciation later.
- Ensure you are dealing with a reputable sponsor
We have all heard stories of investors becoming victims of Ponzi schemes or other types of fraud. Therefore, it is important to perform proper due diligence on the sponsorship team.
The first step should be to run a Google search on their name. You may be surprised to see what you find.
You can also run a background check on them. There are online services that will do that for you.
Ask for referrals from prior investors.
What is their track record?
- They should be able to share the performance and the latest monthly report on deals they currently are operating.
- Have any of their deals gone full cycle? What were the returns vs projections?
You can also ask who the broker was that sold the property. Call the broker and ask if the sponsor actually has the deal under contract.
- Accredited vs non-accredited
Depending on the deal, you may need to be an accredited investor to participate. This means having a networth of more than $1M, excluding your own home, or making $200K/year or $300K/year with your spouse.
Other offerings may accept a number of sophisticated investors. Sophisticated investors do not need to meet the same net-worth or income requirements as accredited investors, however you must have the ability to understand the risk of the investment you are making and have enough net-worth to sustain a total loss of the investment.
*DisclaimerNothing in this document should be considered investment, tax, or legal advice. It is for education and entertainment purposes only. Always consult with your investment, tax, and legal professional before you make any investment decision.
Investing in private syndications is risky and you may lose all your invested capital.