For the past couple of years, I have been heavily favoring Real Estate Syndications as a way to diversify how I invest in real estate. Real Estate syndications are a powerful investment vehicle that allows you to get exposure to other asset classes other than residential real estate, which is where most real estate investors start. Real estate syndications, for example, provide access to larger real estate deals involving commercial real estate like Multi-family apartment buildings or self-storage facilities, all without having to deal with tenants, toilets, etc. Before I delve into the pros and cons, let's start by defining more precisely what a Real Estate Syndication is.
A Real Estate Syndication is simply a partnership between multiple investors which combine capital and resources to invest in a real estate deal. In legal terms, it is comprised of a Sponsor or General Partner which is typically represented by a Limited Liability Company (LLC). The sponsor or syndicator will typically orchestrate the deal by acquiring and managing the purchase of the real estate property as well as raise money for the deal through the investors. The investors or limited partners generally only provide capital and are completely passive investors in the deal.
Why invest in a Real Estate Syndication?
As mentioned, investing in a real estate syndication is a great way to give you exposure to how real estate deals are transacted, especially if you're just starting out. Perhaps you have a W2 job and do not yet have the time, resources or experience to invest in real estate. Real estate syndications provide the benefits of real estate investing such as cashflow, appreciation, and tax benefits without the hassle of dealing with the day-to-day operations. In addition, investors minimize their risk by leveraging the resources and expertise of the sponsor and their team.
Typically, investor returns are divided into two classes and the following is an example:
Class A investors are paid a fixed return of 10%, but do not participate in upside when the property is sold. Their internal rate of return is said to be 10% IRR.
Example: You invest $50,000 in a syndication deal as a Class A investor. You would receive periodic (monthly or quarterly) distributions. Since you'll be getting a fixed 10% return, your return over the year would be $5000.
Class B investors are paid a preferred return of 7% and would also participate in the upside when the property is sold. Class B investors would also receive periodic (monthly or quarterly) distributions, but at a 7% return, but only after Class A investors are paid first. This is typically referred to as the Waterfall payment structure. However, Class B investors also participate in returns after the sale of the asset as equity partners. These returns are typically split between the Limited Partners (LPs) and General Partners (GPs) after a certain hurdle rate is reached. The actual returns are based on the performance of the asset at the time of the sale (occupancy and the resulting net operating income it produces, for example). At the time of this writing, many of the Real Estate syndications sponsors will typically target about a 12-15% IRR for investors and will tout a 1.50 - 2.0x equity multiple.
How to choose a Syndicator and Deal?
In the past, real estate syndication deals were only available to wealthy individuals and private equity firms. It was only until recently when certain tax law changes were put into effect that it was made available to other investors. That being said, this has also led to a rapid rise in the number of syndicators or sponsors to choose from, many offering attractive returns for their investors. It is important to find a sponsor that is well-versed in the specific real estate asset class and location of the target property. Furthermore, there are various factors to take into consideration before investing with a real estate syndicator. Care should be taken to understand if the sponsor:
Is acquiring the property at a prudent price compared to similar properties in that specific location, given current market conditions. Metrics to look at here may be the purchase price, going in cap rate, current occupancy, current rent per square foot compared to neighboring properties, and the amount of deferred maintenance.
Has a well thought-out business plan and exit strategy during the hold period, such as a value-add play to increase the net operating income of the property. For example, perhaps the syndicator plans to renovate the property and increase rents, or reduce cost by leveraging an onsite property management company. The business plan should lay out in detail what the plans are and how much it costs with built-in proper contingencies for any renovations.
Has performed a thorough analysis of the location and has reviewed metrics such as rent growth, population growth, job growth, employer diversity, and other tenant demographics that make that location attractive.
Has a consistent track record for exited deals that meet or exceed the returns for their investors, as well as being transparent with any fees being charged as part of the deal.
Has performed a sensitivity analysis. For example, with multi-family syndicators it is a common technique to use a sensitivity analysis showing the prospective returns for investors using exit cap rates or occupancy rates if market conditions are less than ideal when the property is sold.
Has skin in the game. Sponsors who invest large amounts of capital alongside the limited partners is a good sign that the deal is favorable for all parties, and will be motivated to ensure the deal is profitable.
While investing in real estate syndications do come with a lot of perks, they are not without some challenges. Below is a summary of the Good, the Bad, and the Ugly when it comes to investing in these investments.
The Good (Pros):
Does not require any time or expertise to manage the property or tenants. Real estate syndications are typically professional managed by experienced and skilled real estate professionals, which eliminates the need for investors to have in-depth knowledge of the industry.
Completely passive investment that provide cash flow and appreciation during the hold period.
As a limited partner, your risk of liability concerns is minimized and is shared amongst the other investors.
Access to larger and more lucrative real estate investments such as commercial real estate deals. Syndication allows investors to pool their resources and invest in larger and more profitable real estate properties than what they could individually afford. They also allow the investors to take advantage of economies of scale to minimize capital expenditures and operational costs.
Diversification: Real estate syndication can potentially provide investors with a diversified portfolio of properties across different asset classes, geographic areas, and investment strategies, minimizing risk.
The Bad (Cons):
Many syndication deals require you to be an accredited investor. Certain conditions must be met to be an accredited investor such as having a net worth of $1 million or more or income requirements of $200,000/year or more ($300,000/year if you are married and file jointly).
High Investment Minimums: The minimum investment amounts for syndication can be quite high, making it difficult for smaller investors to participate.
Lack of liquidity of your investment during the hold period. Syndicated investments are often illiquid, which means investors cannot easily sell their shares, and it may take several years to realize a return on their investment.
The Ugly (More Cons):
Lack of control for investment decisions, management decisions and exit strategy. For example, it is up to the sponsor on when to sell the property which may trigger a tax bill for that year.
Communication: Syndicators may not provide clear and timely communication about the performance of the property to their investors, leaving them in the dark about their investment.
Since a syndication is a partnership, taxes can be a bit more complicated and typically requires filing a K-1 form. In addition, some operators of the syndication can be slow to send out K-1s during tax time.
Real Estate Syndication sponsors typically charge fees ranging from 1-5% of the project size. These fees could include Acquisition fees, Disposition fees, and Assets Under Management Fees (AUM), etc. so it is important to understand these fees and how it may affect your investment/performance of the project.
As with any investment, it is important to weigh the costs and benefits of real estate syndications and make sure they are the right type of investment for you.
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