What are Real Estate Syndications?
In this article, you'll learn how RE syndications work and the ways they can financially benefit their participants.
If you've ever been driving down the road or flying in an airplane and wondered who owns that big skyscraper, or large apartment community, there's a good chance the answer is people just like you. Real Estate syndications are private offerings that pool investors' money together, so that everyone can participate in the purchase and reap the rewards of the investment. You may have heard the term "private equity" before, and this is precisely the same thing. In real estate, it's possible to syndicate apartments, office buildings, retail space, mobile home parks and more. So, how does this all work?
GP's & LP's
The syndication process begins with the General Partner (GP), also referred to as the operator or sponsor. Their team, more times than not, will be made up of 2-4 individuals. Their responsibilities in the syndication are:
Finding the investment opportunity
Raising money for the investment
Working with lenders
Maintaining a relationship with the Brokers
Underwriting the opportunity
Due diligence on the asset
Communicating and reporting to investors
Asset Management (overseeing property management)
The list goes on...
In short, the General Partners oversee the day-to-day operations to ensure the asset being invested in will perform. The GP's are responsible for creating a legal entity structure (typically an LLC), and issuing membership of the LLC to their investors, which are called Limited Partners (LP's). As the name suggests, Limited Partners are passive partners and only responsible for contributing capital to the investment.
The Flow of Money
A waterfall is the fancy term that describes the flow of money in a syndication. In exchange for the LP's invested capital, a return is generated through the efforts of the sponsorship team. An offering's return structure can vary greatly from deal to deal, asset class to asset class. Because we operate in the world of Multifamily, I'll outline a typical apartment syndication's return structure.
A simple waterfall structure (and they can get complicated!) will have a 7% Preferred return with a 70/30 profit split. In our deals, the goal is for our investors to generate a 2x equity multiple in 5 years. Let's identify these terms:
Preferred Return - the return that must be paid out to the LP prior to the GP earning any profit from the deal.
Profit Split - pretty self explanatory. The LP's receive 70% of the profit and GP's receive 30%. Again, this split only kicks in once the LP earns their 7% return.
Equity Multiple - The multiple you will see on your investment by the end of the deal. For example, if you invest $50,000, you would receive $100,000 by the end of the investment timeline (assuming it is 2x).
Time to put these to work in an example. Let's assume you invest $50,000 as a Limited Partner with the 7% Preferred return and 70/30 profit split. The investment is being held for 5 years. Your annual cash distributions are as follows:
Year 1: $2,500 Year 2: $3,000 Year 3: $3,500 Year 4: $3,500 Year 5: $4,000
Respectively, on your $50,000, you are earning 5%, 6%, 7%, 7%, and 8% per year. Although the amounts are not staggering, time value of money is important - cash in your pocket today is more valuable than cash in your pocket later. This could be used calculating an internal rate of return, but for the purposes of this article, we'll keep it simple. Taking an average of your annual returns over the 5 years, you've earned 6.6% on your investment. This amount totals $16,500. However, based on your 7% Preferred return, you should receive $17,500 over the life of the deal ($50,000 x .07 preferred return) before the General Partners earn their profit split. The extra $1,000 will be paid to you at the sale or refinance in Year 5.
While I'm all about passive cashflow, the real return is made when the property is sold! Because this investment projection was quoted at a 2x Equity Multiple, you are owed an additional $33,500 in Year 5 ($16,500 cashflow + $1,000 catch up + $32,500 sale proceeds = $50,000 = 2X equity multiple). Using the Rule of 72, doubling your money in 5 years equates to a near 15% return.
Believe it or not, this is a relatively straightforward example. Waterfall structures can get extremely complicated depending on the operator. On our investments, we aim to strike a balance for our investors that is 1) simple to understand and 2) aligns our incentives with yours...we should not be getting paid unless you do.
Okay, so now that we've walked through how syndications are structured and what projected returns may look like, let's highlight some of the benefits of syndication investing.
1) Passivity. If you've ever wanted to benefit from all of the perks that go along with owning real estate, passively investing in syndications is a perfect way to go. Outside of wiring your investment amount and filing your K-1 once/year, there's no work to be done for the Limited Partner.
2) Cashflow. Unlike your 401K or general investing account, syndications (depending on the type) will provide you regular monthly or quarterly deposits.
3) Transparency. This is one of the key reasons I decided to invest in my first syndication. I know exactly who and what I am investing in. There's peace of mind working with an experienced sponsorship team who I know, like, and trust. Beyond that, you can physically see what your money is being invested into and what the money is being spent on via the business plan. This doesn't apply to paper assets (stocks, bonds, mutual funds).
4) Tax Advantages. Depending on the asset class, there's usually invaluable tax advantages. Speaking from my own experience, every dollar of cashflow I earn today from my syndication investments, I do not incur a dime of tax on due to the depreciation write-off. You can find a detailed example of how this works in the Beginner's Guide to Multifamily Investing. (*I am not a CPA or accountant - please consult yours to understand your tax situation, as it is unique to every person.)
No investment or asset class is all butterflies & rainbows - let's take a look at the not-so-good parts of syndication.
1) Risk. I'm sure this one doesn't come as a shocker - with any investment opportunity, there's risk. The deal has to perform in order for you to earn the projected outcomes. In a future article, I will highlight how to set yourself up for the highest chance of success by asking good questions and vetting your operators & their deal.
2) Minimums. Syndications have investment minimums (usually $50,000), due to overhead costs (such as legal & tax), as well the added administrative component. Gleaning investments little by little is not realistic for most syndicators. As a result, these minimums can make it challenging for many people to participate.
3) Limited Liquidity Once your money is invested, you should not expect to access that principal amount for the duration of the investment. Due to the operator needing that cash to implement the business plan, it should not be seen as a liquid investment.
There are certain variables to consider before investing in your first real estate syndication, but the record shows it can be good for diversification, generating strong risk-adjusted returns, and gaining significant tax advantages. Like any investment, it comes with its risks. I personally feel more comfortable taking on these risks due to my ability to physically see the asset I am investing in, as well as forming a relationship with the sponsorship team before committing. A common phrase I have heard as it relates to real estate syndication is "you're betting on the jockey, not the horse". Meaning, it's much more about who you're investing in as opposed to what you're investing in. Developing that relationship and a strong level of trust is crucial.
If you are considering moving forward with your first investment, or even if you've done this before and would simply like to chat through your selected deal & sponsor, I'd love to connect.