How Does Real Estate Syndication Work?
Updated: May 24, 2020
I'm happy to share a special guest post from Pamela Starnes, author of the real estate blog, Physician REI. Pamela runs a medical practice and partners with investors to buy apartments and mobile home communities - similar to our approach. In this post, she tackles a question I'm asked frequently, so I thought it would be great to share this overview on real estate syndications. Be sure to check out her blog and reach out to Pamela at firstname.lastname@example.org.
Since the original publication, I've updated Pamela's original article with more questions that I often receive regarding syndications, along with new resources.
In its simplest form real estate syndication is pooling investor money together and partnering with a private real estate company to increase the purchasing power of the group to acquire larger assets. The partnership formed between investors and the real estate company is designed to be a win/win for everyone involved. Real estate companies looking to syndicate deals focus on acquiring the best investment opportunities and have well established teams to operate these properties. Investors provide equity to acquire properties without having to do the legwork of acquisition and management and then benefit by recognizing a solid return on their investment passively yet still retain the benefits of real estate ownership. The significant difference between syndication and a joint venture is that in a syndication the management of the investment is controlled by the sponsor (general partner) with limited input from individual investors (limited partners).
For this reason, syndications are regulated by securities law. Under the Securities Act of 1933 any offers to sell securities must be either registered with the SEC or meet one of several exemptions. Many sponsors utilize Regulation D (Reg D) exemptions which include several rules to specify who can invest and how the sponsor can market to potential investors. The more broad the range of investors the syndication is open to the greater the regulations and disclosures are to "protect" such investors. This is why many syndication projects are only open to accredited or sometimes "sophisticated" or non-accredited investors.
Frequently Asked Questions About Real Estate Syndication
1. Who can invest?
Many of these syndication deals are only able to be offered to accredited investors to meet SEC regulations. Which SEC registration exemption the sponsor is offering the deal under will determine to which type of investor the sponsor is able to offer the deal and how they are able to market the deal to those investors.
An “accredited investor” can be defined a number of ways but is typically met by either income requirements of $200,000/yr individually ($300,000/yr jointly) or by demonstrating a net worth of $1M (individually or jointly with a spouse; exclusive of your primary residence).
For more information on what an accredited investor is read more at this link.
Some offerings are made available to sophisticated investors that do not meet the accreditation requirements. These individuals need to be sophisticated enough to understand their investment decisions but the pool of investments that you have to choose from is definitely greater once you can be classified as an accredited investor. Typically most people are acutely aware of their annual income and know if they qualify from that standpoint or not. However, if you are not used to tracking your net worth over time it is worth putting together a spreadsheet to do so as often times people will be pleasantly surprised that they actually do qualify as an accredited investor once they see their net worth on paper.
2. How much is the minimum investment?
Most of these investments have an investment minimum of $25,000 to $50,000. Occasionally on larger deals the minimum could be as much as $100,000 but most commonly the minimum is $50,000.
3. What are the tax benefits?
Like all issues tax related, you are always advised to consult with your own tax professional on this subject as it relates to your own individual situation. That being said, the benefits attributed to real estate ownership as an individual are generally passed through on a fractional basis the same way they would be if you owned a property individually. This includes the ability to use the depreciation deduction to reduce the taxable amount of your investment.
4. How long do I have to stay in the investment?
Most syndication investments of this nature are underwritten to a hold period of approximately 5 years. As a passive investor you should expect to be committed for the entire duration of this projected hold period. Occasionally there might be opportunities to sell out of your shares in a deal to another investor but there is no guarantee of the availability or timing of that opportunity so one should be fully prepared to continue in a deal for the initial timeline projected at the start.
5. What types of fees do these investments incur and will that cut into my returns?
Just like the management of any investment you make in something like a mutual fund, there are always managers responsible for optimizing the performance of that investment and compensated accordingly. Syndication deals are no different. From sourcing the best deals, negotiating the deals, obtaining financing for a deal, raising capital, managing a deal throughout its lifecycle, and ultimately selling a property, there are a multitude of time and expertise intensive tasks along the way. Naturally, the managers responsible for making these things happen and contributing to the success of the project are compensated for these tasks. However, all of these fees are already calculated into the projected returns you see when evaluating a deal, so any projected cash on cash return/preferred return and IRR projections would be net of fees.
6. What responsibilities do I have as a passive investor?
Your biggest responsibility as a passive investor (limited partner) is choosing a syndication team/deal sponsor wisely (see question number 10 below). Once you have done that and have found a deal that meets your investing criteria, your responsibilities as a passive investor are nominal. You do not have any responsibilities related to tenant management, repairs, or operations of any kind. The asset management division of the sponsor team assumes all responsibilities related to acquiring, operating, and ultimately disposing of (selling) the proposed deal. Throughout that lifecycle you can expect to be communicated with regularly (typically monthly or quarterly) along the same schedule as your monthly/quarterly distributions from the deal.
7. What types of properties are these syndication deals?
A syndication could include the purchase of many things, but for the purpose of this discussion the main types of properties are in these categories: - Multifamily Apartments: this is the most commonly offered asset class in these syndications - Mobile Home Parks: sometimes these may be offered in a fund type investment that holds a number of mobile home parks as one investment - Self Storage Facilities - Assisted Living Facilities
8. What type of return should I be able to achieve on this kind of investment?
Most deals are structured to give the passive (limited partner) investors a preferred return of somewhere around 8% with a split of profits above this amount of somewhere between 70/30, 60/40, or 50/50 (limited partner/general partner) depending on the deal.
A preferred return means the return the limited partner investors receive before the sponsor takes any share of the profits. This aligns the sponsor’s interest with the investor and incentivizes them to meet or exceed projections in order to profit from the operations of the property.
In addition to the preferred return, there will also be a similar split of profits upon any refinance of the property or upon the sale of the property. It is not unusual for the sponsor to consider a refinance of a property within a couple of years of purchase. By this time there has generally been a substantial increase in value of the property based on institution of the value-add plan and this equity can be extracted to give back a portion of each investor’s original investment while the investor still remains in the investment. Once the investor’s share of profit is returned upon the sale of a property it is not unusual to see annualized returns over that period of mid-teens to 20%.
9. What is the investing strategy of these types of investments?
The typical investing strategy of these investments is to identify and acquire properties that have some opportunity for value to be added to them in some way. For apartment building acquisitions this typically takes the form of purchasing a property that has good market fundamentals and a strong tenant base but is in need of some modernization or improvements to the physical structure that can allow for increased rent. Such properties frequently have operational inefficiencies which can also be improved upon such as better property management, renegotiating service contracts, etc. Any of these things that increase income or decrease expenses go straight to the bottom line and increase the value of the property.
With such improvements made, properties are often rebranded with a new name, new exterior improvements/signage to capitalize on a new look and feel to the property. This helps to reposition the property to the desired tenant base being targeted.
10. How do I find and vet a syndication sponsor?
This, of course, is one of the most crucial steps for any passive investor as this will be one of the few components within their control when choosing to participate as a passive investor.
Here is a great article on this topic, which should give you a pretty comprehensive way to evaluate a sponsor. Joining a community like Biggerpockets.com and perusing the forums for input on various syndication teams/sponsors is also a good way to get information on a certain team with which you are considering investing.
(Editor's Note: Here is an additional article on evaluating real estate sponsors which was a series on evaluating syndications)
11. Can I invest retirement funds in a syndication deal?
Yes, generally you are able to use retirement funds through a self-directed IRA (SDIRA) or Solo 401k plan. Self-directed retirement accounts allow you to invest in “alternative assets”, real estate in this case, but require you to use a different custodian of the retirement account that offers self-directed plans. Some large IRA custodians that you may be familiar with (Vanguard, Fidelity, T. Rowe Price, etc.) do not offer the option to invest in these assets through them, but there are plenty of options to choose from in the self-directed space for retirement accounts.
As well, you can frequently invest a combination of retirement and post-tax funds into a deal to meet the minimum investment (ex. $25,000 of self-directed IRA money and $25,000 of personal savings money).
BONUS SYNDICATION QUESTIONS
12. How is this different from a REIT?
There are pros and cons for REITS vs. Syndications. REITs have a lower barrier to entry and are more liquid. Syndications have a higher average return as most project a 75-100% return over a 5-year hold, while REITs typically offer only a 25% return over a 5-year hold. Another big difference is there is more investor access and control in a syndication, even though both are passive investments. With a syndication you have direct access to the income statements, rent roll and most importantly the direct manager of the apartment. Additionally, with a syndication you are investing directly into the LLC that owns the property and this allows you to receive pass-through tax benefits.
13. What are some key things I should look for in any deal?
You want to determine if the sponsor has a sound business plan, a capable team and conservative projections. The business plan should fit the demographic for the area with supporting evidence. The team should have experience implementing the selected business plan, especially the property management team and asset managers. Projected rents should be below the top of the market and a sensitivity analysis should be included to show the elasticity of the deal.
14. What is a sensitivity analysis?
This is a matrix that shows how projected returns fluctuate when another metric changes. You may see specific metrics included such as the exit cap rate, the net operating income (NOI), and economic occupancy. You want to ensure the project has room for fluctuations and works even outside of optimal projections.
15. Who is an ideal passive investor for syndications?
To determine if passive investing is the ideal strategy for you, answer the following three questions:
Are you busy with your full-time job and other life activities but still want to invest in apartments?
Do you want the benefits of owning an apartment building but don't have the time, capital and/or expertise to acquire one by yourself?
Are you comfortable handing over control to an experienced team?
If you answered yes to all three questions, you would be an ideal passive investor.
Hopefully this has helped you gain a framework for understanding how a multifamily syndication works and whether it might be a good fit for your investing strategy. If you would like to learn more and stay informed of syndication deals in our pipeline, join our email list and download a sample deal here.
You can also reach out to our guest author, Pamela Starnes at email@example.com and check out more of her info at physicianrei.com.