What is real estate syndication? How does it work? And is it a good investment option? Read on to find out the answers to all these questions and more.
The term “real estate syndication” sounds so complex, right? Well, let it not fool you. It is just a fancy term used to represent partnerships in real estate investing.
Some time back, real estate investing was left only for the wealthy. This is because it required a lot of money to acquire real estate assets, and only an elite few could afford them. However, things have significantly changed over time, especially with the aspect of real estate crowdfunding, made possible in 2012 through the JOBS Act.
Now, people can join hands and contribute what they have to come up with the required amount to buy a property. In other words, it's possible to pool funds to invest in a real estate property, even for the not-so-wealth folks.
Real estate syndication is one option of funds pooling that makes it easier to invest in the real estate industry. But how exactly does a real estate investment syndicate work? And is it the right investment option?
Let us start with the basics.
What is Real Estate Syndication?
In simple terms, real estate syndication is an investment structure whereby multiple investors come together to purchase real estate properties. Instead of investing in it alone, you pool your resources with other real estate investors and buy real estate as a group.
Usually, a real estate syndication has two sets of members; the sponsor, also known as the general manager, and the investors or passive members. And each of these people has their role in making sure that the real estate investing venture becomes a success.
When it comes to the contribution of funds, these members also contribute differently. For instance, the sponsor mainly contributes “sweat capital” plus 5-20% of the total investment. On the other hand, the other investors (passive investors) contribute around 80% to 95% of the required equity.
In some real estate syndications, you might find a third wheel or partner, known as the Joint Venture Partner. Their work is mainly oversight.
The Role of a Sponsor
As I have mentioned above, a real estate syndication mainly involves two parties. The sponsor, also known as the general manager or the real estate syndicator, is one of them.
Usually, the Sponsor is the driving for of this investment's day-to-day activity. They do almost everything to ensure that this project is a success. The main duties of the sponsor include:
- Finding the right property
- Raising capital and sourcing for investors
- Completing due diligence on the specific property or properties
- Creating a business plan
- Underwriting the deal
- Negotiating for a better buying price
- Property management
- Dealing with investors
In other words, the sponsor is the brain and the driving force for a real estate syndication investment. They are the ones that ensure proper property management is done to guarantee good returns on investment for the investors.
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The Role of a Passive Real Estate Investor
Generally, the role of this set of investors in real estate syndication deals is to provide capital or finances for the project. While the Sponsor also contributes a certain percentage of the capital, the passive investors inject the largest portion of capital into the project. For example, they can contribute anything from 80-90% of the property's total cost.
In exchange for their contribution, the investors receive shares of ownership on this property. This allows them to share in the revenue and profits made on this property. The investors can receive distributions on a monthly or quarterly basis, mainly if the property is a rental.
However, if the property is renovated and flipped, they will receive a portion of the total profits based on the agreed profits division structure. So, generally, the work of passive investors is to raise investment capital and wait for profits.
The Role of a Joint Venture Partner
This third set of real estate syndication partners has a major role of oversight. They are usually found in massive real estate syndications and help to ensure transparency and communication between all partners.
If the investment involves numerous investors, communication is key, and the Joint Venture Partners ensure that everyone is comfortable. In some instances, they might also help with issues of reporting and taxes.
Business Structure: How Does Real Estate Syndication Work?
As seen above, a real estate syndication involves a general partner who oversees the acquisition, property management, and sale of a property. It also has passive investors who provide funds. As such, real estate syndications can be structured either as a Limited Partnership or a Limited Liability Company.
In this light, the LP Partnership Agreement or the LLC Operating Agreement documents are vital, depending on the chosen structure. The documents help to guide on issues regarding the Sponsor's rights and acquisition fee, voting rights, and distributions. They are essential in protecting the rights of both parties if something goes wrong with the syndication.
Interestingly, these two business structures resemble other investment setups, such as private funds in Venture Debt, Private Equity, or Venture Capital.
Benefits of Choosing Real Estate Syndications
There are several benefits to real estate syndication that make it an attractive option for real estate investors. For one thing, by partnering with other real estate investors, you have access to more capital than you can raise alone. This allows you to invest in bigger or more expensive properties than you might otherwise be able to do on your own.
Additionally, real estate syndication has the ability to reduce risk through the diversification of investments. By joining forces with other like-minded investors, you can spread your risk more effectively across real estate properties. This way, you minimize the potential for loss.
Other benefits of Real estate syndication deals include:
1. Passive Income
For the passive real estate investor, this investment offers a source of passive income. This is because they do nothing to help manage the investment besides their contributions.
They will usually receive monthly or quarterly payments without putting in more effort. So, if you are trying to find a great passive income stream, real estate syndication might be the real deal.
2. Hassle-Free Earnings
Dealing with tenants or managing a property can be quite a headache. But with this type of investment, the Sponsor does all the hard work.
In return, the investors earn hassle-free rental income. Who wouldn't want that?
3. Diversification
When trying to build wealth, diversification in investments is paramount. Real estate syndication allows you to achieve just that. Here, you can invest in multiple real estate syndications and diversify your real estate portfolio.
4. Tax Benefits
Real estate property owners enjoy several tax benefits. These include depreciation tax benefits, lower taxes on capital gains, mortgage interest deductions, and 1031 Exchange. In essence, you'll have more benefits when you invest in real estate syndication besides the rental income.
5. Property Appreciation
Real estate investments have a history of property appreciation. And real estate syndication is no exception.
If you are looking to grow your wealth, real estate syndication could be just what you need. It's an excellent way to increase your ROI (return on investment).
6. Better Investment Control
With real estate syndication, you retain some real estate investment control. For instance, you can communicate with the Sponsor to better understand what is happening to the project. This aspect is not available in most other investment options like crowdfunding platforms, mutual funds, or even REITs (real estate investment trusts).
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Disadvantages of Real Estate Investing Syndicates
Despite opening the doors for less-wealthy investors to invest in real estate, these types of investments also have some drawbacks. These include:
- Failure to make profits: While real estate properties are mostly considered a sure way of making profits, the deal might sometimes go south. If this happens, the investors will either lose or not make profits at all.
- You have to be an accredited investor: This means that you need to have earned over $200,000 annually in the last two years or that your net worth surpasses the required $1 million mark.
- Sponsors do a lot of work: Sponsors have to source for the property, negotiate for a good price, find investors, and even contribute funds themselves. Now that's a lot of work.
- No Control over the Investment: It is true that investors have better control over the investment here than with other investment setups. However, they still don't have total control. The Sponsor manages the property and determines how profitable the investment becomes.
- Working with many investors can be a headache: It's never easy working or investing as a group, especially when it comes to decision-making. Sometimes, failure to make prompt decisions might even bring about losses.
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Sharing Real Estate Syndicate Profits
Real estate syndications make money in two main ways – rental income and appreciation. This is the income that is shared between the Sponsor and the investors.
When dealing with rental income, the Sponsor distributes it to the passive investors either monthly or quarterly. The distribution is usually dependent on the preset rules.
As the property appreciates over time, investors can receive higher earnings in rent. In addition, property appreciation means more money for the investors when the Sponsor sells the property.
These two types of income are mainly dependent on the time it takes for the investment to mature. For instance, it is between 6 and 12 months for some syndications, while others might take even ten years to mature.
Sponsors enjoy profits first for the acquired profit. This is known as the acquisition fee and is paid for the work done in sourcing and acquisition of the investment property. Usually, the fee ranges from 0.5 to 2%, but the average is 1%.
But when it comes to sharing profits earned from the property, investors are the first ones to taste the fruits of their investment. They are first paid what is known as the preferred return, even before any other cash flow. Preferred return for investors can fall anywhere between 5% and 10% of your invested money and is paid annually.
Types of Real Estate Syndication Deals
Real estate syndicates can be in either of these two forms:
1. Straight Split Syndication
It is the first and simplest type of real estate syndication. Here, the profits are shared proportionately among the investors.
For example, if 10 investors contribute equally to the purchase of the property, each investor will receive an equal amount of profit. On the other hand, if there were some investors who contributed more, they are entitled to a larger share based on their contribution.
2. The Waterfall Structure Syndication
Things get a bit complex with a waterfall syndication deal. It is not as straightforward as with the first deal.
But what it simply means is that the profits are shared based on the percentage of return. When the property's performance increases, the preferred return also rises, and so does the share of profits.
Dividing this into levels can help us understand the structure better. For instance:
- First Level: If the preferred return is 7%, any returns falling below this go to the passive investors. The sponsor gets zero.
- Second Level: If the returns exceed the 7% preferred return mark, the investors and the Sponsor shares the profits on a 70/30 basis.
- Third Level: If the returns surpass 14%, the general partner and the passive partners get equal shares. It becomes a 50/50 split.
As you can see, the better the returns, the better share of the profits the Sponsor gets. Therefore, this structure of investment encourages or incentivizes the Sponsors to work harder and produce better results.
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What is a Real Estate Syndication Preferred Return?
A preferred return is usually the minimum amount of return an investor should expect from his investment. This concept plays a critical role in real estate syndication deals, as it helps protect investors' interests and encourages them to participate in these types of deals. It is paid to the investors before the Sponsor can share or receive the performance fee.
The Sponsor generally sets the preferred return before the investors make any investment. It can vary from 6% to 9%, depending on market conditions or the risk of a specific investment. However, some types of syndication also offer higher rates of preferred return, such as 12%.
This return can be compared to interest on your money, except that it's not always guaranteed. It usually depends on the performance of the property.
Real Estate Syndication Example
Let us take one example to help you better understand how real estate syndication works.
Assume a Sponsor spots an excellent real estate deal that requires $800,000. However, the Sponsor lacks the full amount to pay for the property themselves. As such, they source for three interested investors to chip in and raise the equity.
But to entice the investors, the Sponsor needs to promise them something in return. So, he promises to offer an 8% preferred return.
Now, assume that the Sponsor contributes 10% of the amount while the other three investors share the other 90% equally. It means that each will contribute $240,000.
If the investment fetches a 7% rate of return, it means that the passive investors will share (7% of $800,000) $56,000 amongst themselves. Each will get around $18,666, while the Sponsor gets nothing from the profits since the rate of return is below the preferred return of 8%.
FAQs
What is commercial real estate syndication?
It refers to a process in which multiple investors come together to purchase, develop, or manage an income-generating property. The syndicate is typically led by an experienced real estate investor or developer who serves as the general partner or managing member of the entity. Other partners, the passive investors, only come in to raise the necessary capital.
Why is commercial real estate syndication attractive to investors?
Participating in commercial real estate syndication allows investors to access larger investment opportunities than they might be able to pursue on their own. Syndication also provides investors with greater diversification and better risk mitigation than they might have alone.
How does real estate syndication work?
The process typically involves identifying a good investment opportunity, raising capital from multiple investors, and forming a legal entity to hold title to the property. Investors receive distributions based on their ownership share in the entity that owns the property, as well as any preferred return they are entitled to.