You may have heard the word “syndication” being used in relation to real estate investments without knowing exactly what it means and how such deals are structured. In the most basic terms, a syndication is a group of people that come together for a common purpose. In our case, we create a syndicate with the purpose to purchase multi-family real estate. We pool our money to purchase a property that is larger than we could otherwise buy on our own. Buying a larger property provides a lot of benefits in terms of better management, consolidated operations, and spreading the risk across more units. Larger properties have better financing terms and through optimized operations can generate a lot of value for our investors.
Partners in a Syndication
A real estate syndication is divided into at least two partner classes. There are general partners (GPs), whose role is to source the deal, perform underwriting, secure the financing, raise the equity, and manage the investment after it closes. The general partners take on a significant amount of work and need to have experience, broker connections, good credit, and net worth. The GPs also sign on the loan and risk their assets if things do not go as planned. The GPs will perform the day-to-day asset management of the deal after it closes.
In partnership with the general partners, we have limited partners (LP). The role of the LPs is to bring equity, i.e., downpayment, to the deal. The limited partners are completely passive in the deal. You invest in the deal with the expectation that the GPs are competent and will operate the deal in a manner that will generate a profit to the LPs and the GPs. The LPs only risk their initial investment and are not liable for the mortgage on the property. Since a limited partner is passive, it may not be the best choice for all investors. I wrote about the difference between active and passive in my article, Active vs. Passive Real Estate Investing. Refer to that article if you want to understand which approach may work best for you.
Returns in a Syndication
The main reason for investing in a syndication is to generate a return on your capital. The returns are typically divided into cash flow and equity growth. Most syndications pay an annual return of 6-9% on the cash invested. This is known as Cash-on-Cash return.
This return can be expressed as a straight split of all the cash flow between the general partners and the limited partners. You will typically see 70/30 or 75/25. This means that 70-75% of the cash flow is paid to the LPs and 20-25% to the GPs.
Another option is to offer a Preferred Return (Pref). For example, 7% followed by a 70/30 split. In this case, the LPs will earn the first 7% of the net cash flow and then about 7% is split 70/30 to the LP. This may seem like a better return to the LPs, however, in syndications with a Pref, the GPs typically take an Asset Management fee before the LPs are paid. The next section describes the fees in a syndication. The investor will also earn a return when the property is sold or refinanced. Typically, syndications have a timeframe of 3-10+ years. When the property sells, the investors will receive their pro-rata share of the capital gains of the investment. Quite often you will see that the cash flow during the hold time is about 50% of the return of the investment, while the capital gain at the sale is the final 50% of the return.
Most syndications aim to return an average return of 15-20% and an Internal Rate of Return (IRR) of 14-16%.
Fees in a Syndication
Like most other types of investments, syndications have fees associated with them. There can be several fees involved, but the main ones are:
Acquisition Fee: This ranges from 1-4% of the property purchase price, and is charged at the start of the syndication to compensate the GP team for sourcing, underwriting, raising capital, and closing the deal.
Asset Management Fee: This is a 2-4% fee of the gross rents to compensate the team for managing the investment. This includes traveling to the site, meeting with the property managers, communicating with investors, and ensuring that the business plan is implemented.
Disposition Fee: This is a 2-4% fee of the sales price that some syndicators charge when the property sells.
It is important to understand which fees are involved in the syndication. Everyone needs to be compensated fairly for their work, but some syndicators charge much higher fees than others.
Investing in real estate carries significant risk. An LP investor’s risk is limited to the invested amount, but if the deal fails, the investor could lose all their money. The main risks in a syndication are market risk, credit risk, property risk, and management risk.
Market conditions may change, so vacancy goes up or rents stay lower than expected. Credit markets may change, making it harder to refinance the property or interest rates may rise, which could reduce the value of the property.
There is also the risk that the property has unknown defects that need to be corrected at a high cost to the owners.
Finally, the management team of the property may fail to operate it profitably, thus reducing the value of the property.
These are all risks that need to be considered when investing. However, larger deals like you typically see in a syndication are quite often more stable than smaller deals. The investor should review and consider all risks before investing.
Accredited vs sophisticated Investors
When you invest in a syndication, you are essentially investing in an unregistered security. In other words, you purchase a share of a deal with the expectation that the operator will generate a profit for you. Since such deals are considered to be risky by the Security and Exchange Commission, the investor needs to meet certain requirements to be accepted into the opportunity.
The investor qualifications depend on the type of exemption the deal uses. If the investment is a Reg D 506(b) syndication, accredited and sophisticated investors are allowed. If the investment is a Reg D 506(c) syndication, only accredited investors are allowed.
An accredited investor is someone that has a net worth of over $1M or earns $200K per year personally or $300K with a spouse. Your primary home is excluded from the net worth calculation.
A sophisticated investor is a person that doesn’t meet the net worth/income requirements above but does have some experience in investment real estate, stocks or bonds tradings or other self-directed investing experience. The definition is not very exact, but the sophisticated investor needs to understand the risks involved in the investment and be able to financially withstand the financial loss should the investment fail.
The final topic is about the tax benefits of investing in a real estate syndication. When you invest in a syndication you get many of the same tax benefits as you would if you purchased a rental property investment yourself. The expenses, depreciation, and interest deductions are passed through to passive investors, which often leads to a “paper loss” on your tax statement, even though the investment paid monthly or quarterly distributions. This paper loss can be used to offset income from other passive investments. Just keep in mind that the depreciation deduction needs to be recaptured when the property sells again.
Disclaimer; This article has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or investment advice. You should consult your own tax, legal and investment advisors before engaging in any transaction.