Understand Real Estate Syndication Part 3

Real estate syndication deals are about making money. So, it’s important to understand where an investor’s money goes, as well as how it grows and is returned. The best way to do that is to look at some actual deals. In this article, we will examine two deals offered by Wilson Investment Properties through its partner network: an income property co-managed with Liquid Capital and a development deal co-developed with Hartford Land Management and Hallmark Funding.

Show Me the Money

Forest Cove is a commercial multifamily property with 646 apartment units in Doraville Georgia. It was purchased in March 2019 for $63.5 million and an additional $8.2 million set aside for capital improvements, reserves, and closing costs for a combined $71.7 million. This was financed through investor initial contributions of $18.1 million and a loan of $53.6 million.

Forest Cove Apartments

The investment strategy is for the general partners to leverage their expertise to efficiently upgrade units and facilities, in order to increase occupancy, raise rents and drive greater income generation and ultimately realize a profitable capital exit via an increased sales price. The projected hold period for buying, improving and selling the property is 3 years. The preferred return for Forest Cove is 8 percent and the projected internal rate of return and annual average return are 16.2 percent and 17.6 percent respectively.

In the first full quarter of operations, the new property management team increased average rents, maintained occupancy at 92 percent and began several improvement projects. This resulted in effective gross income of $1,750,432, based largely on income from rents. This is an amount that should grow with time as improvements are finished, occupancy increases and rents rise. But, how much of that flows to the investor?

The short answer is that for every $50,000 investment share an income distribution of $584 was paid out for the quarter. Then there is the long answer….

Breaking Down the Numbers

Rents and other incomes from the property generated about $1.75 million in effective gross income (EGI). Total expenses around all the costs to manage and improve the property subtracted $792,494, leaving $957,937 in net operating income. Debt service for the loan subtracted another $677,765, resulting in a positive cash flow of $280,172.

Some of that cash went out in the form of the income distribution to limited liability partners. Some go to pay the management fee of the general partner. Some might be categorized as deferred income and stay as available cash to pay for future expenses.

Let’s dive a little deeper into expenses. Property management costs are typically 3-5 percent of annual gross revenues. Asset management fees are often 1-2 percent of gross income. And 5-8 percent of the purchase price is often raised to cover replacement reserve expenses to maintain the property, which often works out to about $0.20 per square foot. However, the capex budget for improvements differs from the project.

In no small part, the success of any real estate syndication investment depends on the ability of the general partner to accurately forecast and expertly manage expenses, as well as generate top-line growth by increasing incomes and improving the property to realize a capital gain profit with the eventual sale.

When the property is finally sold and all expenses and costs paid, the remaining cash is distributed. First off, is a final income distribution that pays the investor preferred return prior to any management fee being paid, with any remaining income also distributed to limited liability partners. With all the income generated by the property paid out, the next step is to payback investors for the money initially invested via a return of capital investment return.

After this payout, any remaining cash represents a capital gain from profits made in the sale of the property. If needed this money will be first tapped, to pay any remaining amount needed for the preferred return. In this deal, the remaining profit is to be split 70 percent to limited liability partners and 30 percent to the general partner, until a return on investment of 15 percent per year is realized. For any additional profits, the split moves to 50/50. This type of payment schedule for capital gains is typically referred to as a distribution waterfall.

As with any investment, the calculations don’t end there, as there is still the matter of the government collecting taxes. The good news here is that investors are not taxed on the full amount of income distributions. They receive a K-1 statement, where the depreciation for real estate properties allowed by the IRS is deducted, and they only pay income taxes on the remainder. Of course, the return of their initial investment amount is not taxed, and above that amount they are subject to the long-term capital gains tax for capital gain profits as applicable to a taxable account or in the deferred tax status of a self-directed IRA account.

Not All Deals are the Same

Many deals look relatively similar. Among these deals, one of the meaningful differences for the expense calculation, which can come into play, is around real estate taxes, improvement costs, and insurance. For example, some industrial or retail commercial properties often involve so-called triple net deals, where tenants are responsible for paying taxes, improvement costs and insurance.

But the one type of syndication deal that can look very different is a development deal, where entirely new buildings are constructed and relatively minimal or even no rental income is generated. Paradise Valley Assisted Living is one such development deal. In 2017, the land was purchased for $2.2 million and a further $3.8 million raised to cover the debt service, entitlement, and construction costs, plus reserves.

The subsequently entitled land was valued at $5.5 million or a $3.3 million increase over its original purchase price after the investment in the necessary entitlement activities, including zoning, regulatory filings, and feasibility studies, enabled it to achieve shovel ready status and be approved for construction. The increased value of the entitled land was contributed as equity for the project. Adding all contributions, along with the project's construction debt results in valuing the size of the deal at over $22 million.

Paradise Valley Assisted Living

The investment strategy was to purchase favorably located and priced land suitable for building an assisted living and memory care facility with the architect and staffing operator part of the overall sponsor team. The inclusion of the staffing operator is a critical component in the viability of this particular deal around a healthcare facility. The projected holding period is five to seven years, and the projected IRR, the average annual return of 25 percent and 27 percent, respectively, with a preferred return of 15 percent during entitlement of the land and 10 percent during construction and operation.

Development costs involve both hard and soft costs. Hard costs are directly related to construction. Soft costs include such items, as feasibility studies, property and state taxes, accounting, noise studies, engineering, and architectural fees, permit and legal costs and so forth. During entitlement and construction, there is no income and no distributions. However, during the operational phase after opening, assisted living guests will pay rental income which will be distributed to investors.

The returns for this project are based on operating the facility at a profit and selling the land and buildings for more than it cost to buy the land and build the facility. The complexity comes in when you consider the expertise you want from a general partner to successfully manage everything involved with constructing a new building. Developer fees in a project like this are often 5 percent of the cost of a development project.

Upon the project’s conclusion, with the sale of the property, the initially invested capital must be returned and the preferred return paid out to investors first. In terms of the remaining profits from the sale, the profit distribution waterfall for Paradise Gardens is 70/30 in favor of limited partners, until a 10 percent ROI is achieved, 30/70 until 15 percent ROI is achieved, and finally 15/85 beyond.

For a development deal, it’s largely about controlling development costs and expenses and selling the completed property for a profit. So, it’s extremely important to work with a general partner who understands how to successfully manage such projects and has a track record of success. From a financial perspective understanding real estate syndication deals are really not all that complicated.

Many of the expenses are basic costs around owning, managing and developing the property. The financials can actually be disarmingly simple. Almost anyone can understand real estate syndication. But that does not mean almost anyone can successfully execute on even seemingly simple value creation strategies. It’s why Wilson Investment Properties works with experts with strong track records, who specialize in certain types of property deals, like Liquid Capital for multifamily projects and Hartford Land with Hallmark Funding for development deals.

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