A real estate syndication is a strategic investment approach where multiple investors pool their resources together to purchase an investment property. Rather than being limited to only the size and type of property that each investor could afford individually, they use the group’s funds to scale up and acquire a more expensive investment. This can, in turn, unlock larger potential returns while at the same time spreading out the risk that each individual must bear.
To help ensure their investment returns a healthy profit, the investors partner with a real estate expert, called a sponsor, to guide them through the purchase, financing, management, and eventual sale of the investment property. Because the sponsor handles the majority of the work, syndications are considered a “passive” investment opportunity. They are a great option for busy professionals (doctors, lawyers, etc.) who have the required capital for investing but not the time.
Thanks to a rise in the number of online investment tools along with key legislative changes, real estate syndications are now easier to coordinate than ever before. Investment opportunities that were once found only in private networks are now out in the open for interested parties to review. And sponsors, such as Birchstone Investments, can turn to crowdfunding or other new means of fundraising over our old-fashioned Rolodexes.
However, while syndications can be lucrative investment opportunities, you should understand how they function to make sure they match your investment goals and preferences.
This article will explain further how real estate syndications are structured and the key benefits they offer for investors.
How is a real estate syndication structured?
In a real estate syndication, there are typically two roles to fill: that of the investors and that of the sponsor.
Real Estate Investors:
Investors are the ones who bring the majority of the equity funding to the table. They want to make money from passive real estate investing but may lack the expertise and/or time required to make it happen. Depending on the arrangement, they will generally contribute between 80% and 95% of the equity capital.
At the start of a real estate syndication partnership, a company is formed through which each investor will own a stake in the property. This can take on different legal structures, with limited partnerships (LP) and limited liability corporations (LLC) being the most common. The investors are limited partners in this arrangement.
Benefits for the investors include:
The sponsor secures the property and performs the day-to-day operations.
Since they contribute the majority of the equity capital, investors are typically given a priority claim on investment returns (we’ll explain this in greater detail when we discuss profit payouts).
Investing in Larger Properties: An investor who can only afford a residential or small commercial property can join a syndication and buy into a large commercial asset with more promising returns.
Let’s say that you want to jump into real estate investing and that you have $50,000 in capital. You could afford a reasonable 20% down payment on a $250,000 property, but that’s all you can afford.
In a real estate syndication, however, a company is formed to leverage pooled funds. You can still contribute your $50,000, but the purchase price of the building could be, for example, $10 million. Now you’re investing your money in a large commercial property. The larger structure can accommodate a multitude of tenants, reducing investors’ risk. It will also leave significant room for appreciation and positive cash flow.
Real estate, like any investment, involves some risk. In a syndication a company buys the property, not an individual. And as limited partners within that company, investors are partially shielded against liability should something unforeseen occur.
For example, in the unfortunate event of a tenant lawsuit, the sponsor (general partner) would be mainly responsible for damages, and the investors’ (limited partners) liability would be limited by their capital contribution.
The sponsor (sometimes known as the “syndicator” of the investment deal) brings their extensive real estate expertise to the partnership. It’s their job to do the heavy lifting and take on the bulk of the responsibility, typically taking on the role of the general or managing partner. This workload is considered a “sweat equity” contribution to the equity capital. They may also invest some of their own funds, providing the remaining 5 to 20% of the total equity capital.
The sponsor saves the investors significant amounts of time and hassle. They arrange the financing, locate and secure the property, and oversee the day-to-day management functions, either themselves or by selecting a property manager.
It’s a great deal for the investors because the sponsor’s guidance increases the chances that their investment will turn a healthy profit. For example, the sponsor can negotiate more favorable financing terms and scout out undervalued locations that the investors may not have adequate familiarity with themselves.
They also reduce risk in the investment, as they help the investors steer clear of pitfalls they may not be aware of. For example, they avoid properties with far too many maintenance issues or little to no room for appreciation.
Since the sponsor is compensated by equity in the investment and/or performance-based fees, they have skin in the game, so to speak. The upside for them is that, the greater their performance in producing positive returns for the investors, the higher profit they’ll make for themselves. And while failing could harm their reputation, if they perform poorly for the investors, they’ll suffer their own financial consequences as well.
When are profits paid out in a real estate syndication?
One benefit of real estate syndications is that the profit payouts are balanced to effectively motivate and fairly compensate both parties. Specific payout arrangements are made before the acquiring of a property. Real estate syndication returns are typically structured as below.
Investors make money from a real estate syndication through cash flow (e.g. rental income) and appreciation (upon sale of the property), and they also typically get the benefit of what are known as “preferred returns”.
Because they contribute a larger share of the capital than the sponsor, the investors are usually entitled to preferred returns. You could think of them as priority returns. This means that the investors will receive a predetermined share of the profits before the sponsor receives a cut. Preferred returns commonly range from 5 to 10% of the capital contribution, depending on the deal.
If the property generates positive cash flow, investors will receive a share of that – typically on a quarterly basis.
If the arrangement calls for an 8% preferred return:-and the cash flow is below 8%… the investor will take a lesser amount, the sponsor nothing
-and the cash flow meets that 8% threshold… the investor will take their 8% return, the sponsor nothing
-and the cash flow is above 8%… the investor will take their preferred return. They will split the remaining profit with the sponsor, according to the predetermined arrangement.
This could be structured in a multitude of ways and depends on the makeup of the deal, for example, 80/20, 70/30, or down to 50/50.
At the sale of the property, any profits from appreciation will be split between the investors and the sponsor. There are two steps to the process.
Step one, if the investors have not received their preferred return from positive cash flow, it will first be separated from any profits on sale and paid to them.
Step two, like with cash flow, they will split the remaining profits with the sponsor according to a predetermined ratio, such as 70/30 or 50/50.
For example, let’s say the preferred returns have been paid to each investor, and the leftover profit at sale is $1,000,000.Under a 70/30 split, $700,000 will be divided amongst the investors, and $300,000 will be given to the sponsor.
Sponsors take a fee for each job they perform for the company, and because they contribute capital and/or “sweat” equity, they also share in the profits. Sponsors’ payouts often include an acquisition fee, property management fees, and rental income/appreciation. Sometimes they will include a refinance fee or disposition fee.
Like a real estate agent, the sponsor will use their expertise to search for available investment properties. They’ll perform a careful analysis of the potential cash flow and appreciation, ongoing maintenance needs, etc., of each property until they locate one that can produce a strong profit for the investors. Once the property is purchased, they’ll receive a fee for their time and effort, up to 3% and as low as 0.5% of the purchase price, depending on the arrangement. If the deal is for a small property with a low purchase price, the sponsor may have a minimum acquisition fee.
Property Management Fees:
The sponsor is responsible for all day-to-day operations of the property. It’s an enormous responsibility, and they will receive an ongoing fee for overseeing the property themselves or keeping in touch with the property management service and making expert repair, maintenance, and value-add decisions. This fee is based on gross collected revenue and can vary from as low as 2% to as much as 9%, depending on how much work is involved for the sponsor. If a property management service is retained, the sponsor may pay them from this fee.
Rental Income and Appreciation:
After the investors’ preferred returns have been paid, the sponsor will take their predetermined split of positive cash flow and/or appreciation. For example, 30% of the remaining profit in a 70/30 arrangement.
Refinance and Disposition Fees:
These fees are not as common. They typically come into play in order to balance the payment structure between the investors and the sponsor. For example, if the investors have a large preferred return and/or a significant majority share of the equity, these fees may apply to the sponsor’s payouts.
If the property needs refinancing, the sponsor will coordinate the process and could charge a fee between 1 to 2% of the refinancing amount.
The sponsor will coordinate the sale of the property and may also be compensated for that time and effort with a disposition fee, which ranges from 1 to 2% of the sales price.
Who can participate in a real estate syndication?
Most real estate syndications are open to “accredited” investors only, while some also accept “sophisticated” investors.
This is something defined by the Securities and Exchange Commission (SEC) and in simple terms means one of the following:
-as an individual, you have had an income of at least $200,000 per year for the past two years (or if you’re married, you and your spouse had a combined income of at least $300,000 each year for the last two years)or
-either individually or together with your spouse, you have a net worth of at least $1 million (excluding the value of your primary residence).
You will also need the minimum capital contribution, which is generally between $10- to $100,000, with $50,000 common.
Lastly, you’ll need a little time for the investment to mature. Some syndications last a few months while others may take up to ten years or longer.
Is a real estate syndication right for me?
Real estate syndications offer a lucrative passive investment opportunity. The sponsor helps limit the investors’ day-to-day involvement and liability while at the same time the group accesses a larger property and more real estate expertise than they can afford or have the knowhow to perform on their own. And for their capital contribution they get the assurance of preferred returns. It’s a fantastic opportunity when everything is set up just right.
Here are at Birchstone Investments, we play the role of sponsor often, helping investors target undervalued Class B and C Properties with positive cash flow located in the Southeastern United States. If you’re looking to learn more about investing in a syndication, contact our team.
And in a future article, we’ll continue our discussion of syndications by taking a look at how they stack up against another form of passive investment, a real estate investment trust (REIT). Stay tuned!