Understand Real Estate Syndication Part 2

Real estate syndication is actually an old concept. Admittedly, it’s one that has been reimagined for today. Looking back, one of the most famous syndications of all time was the then record-breaking $65 million deal for the Empire State building. That 1961 deal was financed by more than 3,000 investors contributing about $10,000 apiece. Although the basic structure of how investors pool money to buy an individual property has not changed, the Internet has changed syndication in some important ways.

Today, real estate syndication is an evolving aspect of the fin-tech or financial technology world. Although still not widely appreciated, the Internet is helping grow understanding of and participation in syndications. In fact, chances are that you’re reading this article on a digital screen right now. Here, we’ll be covering some basics around both the impact of the Internet and investment returns.

The Empire State Building

Crowdfunding and Collaborating

In September 2013, Title II of the JOBS Acts came into effect, creating SEC Rule 506(c). That meant for the first time real estate syndications could be publicly marketed and sold, but only to accredited investors. Combining this new rule, the Internet changed the syndication landscape.

This meant crowdfunding websites could emerge to market individual real estate deals, often at very low investment minimums. Marketplaces were created where investors could shop for syndications like choosing sodas at a local grocery store. Of course, real estate deals aren’t exactly the same as cola drinks.

However, some real estate operators still prefer more direct relationships with clients. Even for such firms, the Internet is still a good tool for reaching more investors. The Internet has also enabled other business model innovations, such as Wilson Investment Properties model of collaborating with strategic partners. Using online systems and platforms, we can collaborate across the country with a partner specializing in midwest industrial properties or another focusing on developing eldercare facilities.

Our model is built around us having more choices from thousands of deals diversified across metros and categories to then typically pick less than a dozen of the ones we think the strongest to offer investors each year. What both models have in common is more access and choice. The common crowdfunding model means online marketplaces with lots of deals. The Wilson model means just a few deals selected from thousands, for superior value propositions. Neither would be possible without modern technology.

Furthermore, chances are many of you would never have heard of real estate syndication if not for the Internet. However, it’s important to keep in mind that no matter how it is packaged and sold, it’s the expertise of the General Partners and ability to realize the value of an underlying property that often most matters in the end.

Rohnert Park Land Development Syndication by Wilson Investment Properties

Comparing Calculations

If you have gone online and viewed some 506(c) syndication deals being marketed on the Internet or been presented with a 506(b) deal from a syndicator you have an existing relationship with, you likely were provided financial performance numbers. These figures include the projected return on investment (ROI), internal rate of return (IRR), annual total return and the preferred return. And it doesn’t matter if you are buying the Empire State Building or a multi-family apartment complex. The numbers mean the same thing.

Return on Investment (ROI) encompasses all investment returns and is calculated by taking the total amount returned and subtracting and then dividing by the cost of the investment. For example a $100,000 investment that doubled to $200,000, would have an ROI of 100 percent ((200,000 - 100,000) / 100,000)), and an equity multiple of 2x.

The Internal Rate of Return (IRR) differs from ROI in both its complexity and incorporation of the time value of money. Unlike ROI, the IRR favors money earned early and disfavors money earned later. Even with the same ROI, a five year project that generates all of its investor returns in year five at the time of sale would have a much lower IRR, than a five year project with strong income generation from the first year onward. The IRR reflects the desire of investors to earn money sooner, rather than later. Since getting money later is always penalized in the calculation, the IRR will always be lower than the ROI.

An average annual return is a simple calculation of the average of all annual returns over the hold period of an investment. In a syndication deal, a typical hold period might be 5 years. The average annual return is a simple calculation in a real estate syndication deal because income is paid out to the investor and not reinvested. Therefore an investment that grows over five years by 100 percent has an average return of 20% or 100 divided by 5. This is different than an average annual return involving compounding and without ongoing income distributions.

Lastly, the preferred return is the amount an investor, who is a limited liability partner (LP), must be paid before the general partner (GP) managing the deal receives any profit sharing. For example, if a deal has a preferred return of 8 percent, then a limited liability partner investing $100,000 must be paid the full $8,000 preferred return (0.08 x 100,000) before the general partner is eligible for any profit sharing for a given year. The general partner is thereby aligned with the interest of investors and the GP is only able to realize any profit sharing after the LP is paid the preferred return.

Buying the Numbers

So, investing in real estate syndication is really simple in the age of the Internet? You just need to go online and find the best-projected ROI, average annual return, IRR and the preferred return?

Nope.

A big caveat is a word, "projected."

You can see what the actual performance of syndication only after a deal is concluded. When evaluating a new real estate deal, you’re presented with projections. In making those projections, the competency and bias of a syndicator come into play.

The highest projected numbers might come not from the best performing deal, but instead from a syndicator, who lacks modeling competency around anticipating financial risks or has an aggressive bias for creating projected numbers that look great and will help market a deal to new people. Such an aggressively optimistic syndicator might very well fail to deliver on those promises.

But not all syndication deals have rosy numbers. Some syndicators are like us and seek to have a conservative bias. We perform additional modeling, focused on risk analysis, on top of the initial modeling performed by our strategic partners. Then we make conservative assumptions because we believe it makes good business sense. We do a lot of repeat business with investors. To make sure they come back to us, it’s better to err on surprising on the upside and doing better than projected, because our initial numbers were too conservative.

This logic applies to all syndication projections, including those around the preferred return. Yes, a limited liability investor is guaranteed to receive the preferred return, before the general partner receives any profit sharing. But weaker than expected performance can result in a delay, partial payment or even no payment.

And it is important to note, that there is no guarantee of anything, even with conservative modeling and a smart general partner. Things can still go wrong and there will always be surprises. However, smart assumptions and conservatism mean the odds can be skewed in favor of positive, rather than negative surprises occurring.

The truth is for all of the changes due to the Internet, the fundamentals of the syndication business have not changed. You’re still investing in a specific deal and with a general partner, who will manage it and perform all the financial modeling. Some of those numbers might be more readily available than ever before thanks to the Internet. However, they are only as good as the general partner generating the numbers and the underlying deal itself.

To learn more visit: http://www.wilsoninvest.com