Syndication 101 - Passive Income in Real Estate

Understanding a syndicated real estate investment requires a basic understanding of real estate investing and financing. Real estate is one of the most lucrative asset classes to invest in, but it is also one of the most expensive. Most investors that want to scale (buy multiple properties or buy increasingly more expensive properties without waiting years between purchases) requires financing assistance. There are other benefits to using financing, or leverage, but we'll cover these in future articles.

The most common avenue for financing is bank financing. A bank provides a loan to purchase the property that the investor is interested in. However, the bank almost never finances the full purchase price of a property or set of properties. Generally, a bank requires 20% or more of the down payment to come from the investor or group of investors.

Even with financing, that real estate investor looking to scale will find themselves out of cash at some point. This is where a syndicated investment can become extremely profitable for an individual that 1) may not have the time to find great real estate investments, 2) may not have the time to manage a property or a property management company, 3) may not want the liability associated with direct ownership of a real estate investment, 4) may not have the required capital to purchase their own real estate investment, and/or 5) may not want to deal with the hassles that come with directly owning a real estate investment.

Roles of a Syndicated Real Estate Investment

These two parties make up the two primary roles of a syndicate apartment deal: the General Partner (GP) and the Limited Partner (LP).

The General Partner(s) (GPs) can also be referred to as the syndicator or the operator. For this article, we will refer to them as the GP. The GP is generally the individual or team that identifies an investment opportunity, negotiates the purchase price, conducts the due diligence on the property, will either operate the property directly or will manage a property management firm, will determine cash distributions, and will decide when to liquidate the property. It is possible for large investors to purchase a GP position, but this generally takes a significant amount of capital.

The Limited Partner(s) (LPs) are investors that contribute capital to the investment. An LP's role is strictly passive. They aren't involved in the vast majority of the decisions made on the investment. In exchange for their capital, they are "guaranteed" a profit before the GPs receive their profit. "Guaranteed" does not mean that they will receive a profit, but it does mean they are first in line to receive any profits produced by the investment. Another benefit to being a limited partner is that they are at least one or two entities removed from any liability associated with the investment.

General Partners look to syndicate investments for multiple reasons, but the primary driver for syndicating a deal (as opposed to purchasing the real estate on their own) is because they make more money. Let's imagine that an investor finds a property, invests tens of thousands or even millions into the investment, and now begins the day-to-day operations associated with that investment. Everything is going well, the property is increasing in value, and the property is generating healthy cash flow each month. With everything running like it should, the investor goes looking for another investment opportunity, but they have a problem. Much of their capital is still invested in the first deal. They lack the financial resources to take advantage of this new real estate opportunity, so they syndicate the investment. By syndicating this second real estate investment, the GPs are still able to take advantage of an opportunity that will make them more money. Because they are "sharing" this opportunity, individuals (LPs) who may not have the capital, experience, time, or connections to invest now have the ability to become real estate investors as well.

Benefits of Being a Limited Partner

The motivation to become an LP in a syndicated real estate investment goes beyond the bragging rights of being an investor in a large real estate deal. While these investments are certainly fun to brag about, they provide significant profits to investors. We'll cover the high level concepts in future articles.

Almost all syndicated real estate investments give the LPs a preferred return. This is one of the components that we like most about syndicate real estate investments relative to any other type of investment because the investment's structure aligns the priorities of the GPs with the LPs. The preferred return is the guarantee that the Limited Partners will receive a profit before the General Partners. We want to emphasis that this can't be confused with a guarantee that the investment will be profitable. Almost no investment comes with that guarantee. It does ensure that the General Partners are incentivized to make the investment perform because the GPs don't receive anything until after the LPs receive their preferred return. We've seen preferred returns that range between 6% and 12% with most preferred returns ranging between 7% and 9%. The preferred return's distributions are paid out monthly or quarterly. A good investment summary or offering memorandum provides a pro forma (a budget) that extends out 3 to 5 years. It is important that you review the pro forma carefully because many investments frequently don't pay the full preferred return from the start. In fact, for investments that are focused on increasing the property's value, we prefer to not see the preferred return paid out at the full rate in the beginning because it implies that the GPs raised too much capital which dilutes the overall return of the investment. Any portion of the preferred return that isn't paid out is accrued. Once the property's cash flow is strong enough the LPs' accrued portion of the preferred return will be paid out. This must occur before the GPs are able to take their profit.

Excess profits are paid after the full preferred return has been paid out to the LPs. These additional profits are split between GPs and LPs. This profit split is represented by a ratio like 70/30 or 60/40 with the first number representing the portion that the LPs receive and the second number representing the portion that the GPs receive. A 70/30 split means that for every dollar distributed after the preferred return is $0.70 to the LPs and $0.30 to the GPs. We often see profit splits that are 70/30, 60/40, or 50/50. Some GPs will structure the syndication so that there is a waterfall. The profit is split one way until a certain criteria is met and then the ratio changes to favor the GPs more. A common waterfall we see is a profit split of 70/30 with 70% going to the LPs until an Internal Rate of Return of 15% is achieved. At that point, the profit split changes to 60/40 with 60% going to the LPs.

We love this setup because it truly aligns the GPs' interests with the LPs'. Having spent a collective 60 years in corporate America, we believe this system far surpasses any incentive program that a publicly traded company gives its executive team to protect shareholder interests. The combination of a preferred return and a profit split aligns the GPs' and LPs interest in the short and long-term. We also love the setup because it allows for diversification for both GPs and LPs because all parties can invest in more opportunities.

Profit Sources in Real Estate

Preferred returns and profit splits are nice to talk about, but it is important to understand how your investment is actually making money. We'll provide in-depth analytics into investments in future articles, but having at least a high level understanding is important before handing your hard-earned money over.

Investments generate profits in two ways: cash flow from rental income and/or increased property value. Most investments include an element of both cash flow and longer term increase to value. However, the more value the investment is to generate over time the more capital needs to be invested to generate that value. It takes money to make money. The natural consequence is that some portion of the cash flows from the investment must be reinvested into the property which reduces the cash that can be returned to the LPs or investors early in the life of the investment. This is why the investment may not pay the full preferred return initially; the GPs are investing that money back into the property.

Consider two extreme examples. The first example would include a plot of land that the GPs plan to build on, lease up, and then sell to a third party. This would be an extreme value add because the asset will generate zero cash flow while it remains as land, it will generate zero cash flow during construction, and upon completion of the construction, the asset will be sold and the profits distributed. The second example would be the investors who purchased the newly constructed property from the first example. If the property were purchased at the market rate, there wouldn't be any opportunity to increase the value of the property. Any increase in value would be based on the overall market's increase in value. Since this isn't something that the GPs can control, it shouldn't be something they count on. Since the property is new construction, no updates should be needed. These investors would probably look to receive a steady stream of income from the investment without anticipating an appreciable increase in value over time.

Most of the retail, office space, self-storage, and industrial properties that we review are focused more on cash flow while residential investments like apartment complexes and mobile home communities generally focus more on increasing value over a 3-5 year period. We like to see both initial cash flow and a longer value add strategy in most of our investments. Early cash flows help de-risk an investment and it is nice to see at least some capital being returned. Increased value means a bigger return at the end of the investment, and it helps to de-risk the property if the unexpected happens like a downturn in the economy.

GPs can generate value in several ways. The fastest and easiest way to add value to a property is to buy it below market price. If the market values a property at $1,000,000 and the GPs negotiate a price of $800,000, they immediately generate $200,000 of value. All commercial real estate is valued based on the profits generated; anything that increases income will increase value. Replacing outdated cosmetics that allow a property to increase rents, increasing the occupancy rate so that more tenants are paying rent, and/or decreasing expenses all add value. They also increase cash flow over time.

Once enough value has been created, most GPs will refinance or sell the investment. If it is a refinance, some of the new equity that has been created will be pulled out of the property and distributed to the LPs. Once the full preferred return amounts have been paid, any remaining equity will be distributed in accordance with the profit split. Remember, most banks will loan up to 70% or 80% of the value of a property. If a GP purchases the property at $1,000,000 and the bank finances 80% of the purchase price, the GP must raise an additional $200,000. If five years later the property is now worth $2,000,000; the GP could refinance the property with a loan of $1,600,000. After paying off the original loan, the GP would have roughly $800,000 remaining to distribute to the investors. A refinanced property is a wonderful thing because investors receive some or all of their initial equity and they still have an investment that is generating cash flow. Even better, since this is equity it is not taxable.

Risks of Syndicated Real Estate Investing

Investors can make a substantial return by investing in syndicated real estate. In future articles we'll cover what to look for when assessing an opportunity so that you can identify potentially great deals from the others. We'll briefly touch on risk in this article so that you have some idea of the downside risks that exist with investing in syndicated real estate.

Economic factors are going to universally impact any investment. We'll discuss the impact of an economic downturn in the future (downturns can actually have some positive impacts); but since we are discussing the basics, we won't dive into these risks for this article.

Real estate investing and real estate syndication is not directly regulated by the Securities and Exchange Commission (SEC). Consider a publicly traded company. Publicly traded companies must file quarterly and annual reports with the SEC that meet a high threshold of requirements. For example, an independent third party must certify those quarterly and annual reports. Syndicated real estate investments don't exist under that level of scrutiny. The SEC expects investors to be savvy enough to evaluate and invest on their own. They do this by requiring investors to be Accredited Investors. An accredited investor is anyone who has earned over $200,000 annually for the past two years or $300,000 as a household for the past two years and expects to continue to do so in the future. An accredited investor can also be someone whose net worth is greater than $1,000,000. That net worth must exclude their primary residence. The SEC can step in at any time to scrutinize a syndicated real estate investment, but more than likely they will get involved when some type of law is violated. The threat of civil or criminal action from the SEC does partially mitigate the risk of fraud, but an investor should always conduct due diligence (do their research) when reviewing an opportunity.

The second biggest risk is poor management. A common saying in investing circles which states that a great operator (GP) can turn a good deal into a great deal, but a bad operator (GP) will take a great deal and turn it into a bad one. The good news is that the due diligence for what we see as the two greatest risks to syndicated real estate investing (fraud and poor management) can be mitigated with the same due diligence. We strongly encourage prospective investors to find GPs that have a proven track record to invest with. Investing with a proven operator with a successful track record reduces the likelihood that the operator will lose money through lack of experience or basic incompetence. It should also reduce the risk of fraudulent activity. We also encourage prospective investors to request for and check references on GPs. Speaking with others that have invested as LPs in previous investments can provide important insights. We'll also review properties that a GP has owned in the past to determine if they 1) did in fact own the property and 2) bought/sold the property for a profit. This can be done for free using the local county tax assessor's website. Do not hesitate to ask plenty of questions.

The last set of risks to discuss are those that are personal to the individual investor. These investments are extremely illiquid. It is almost impossible to cash out of an investment early. The good news is that investors should expect to receive a premium on their return relative to publicly traded equities. Prospective investors need to understand that whatever capital is invested will not be available until the investment is concluded. Never invest more than you can afford to invest.

Now that you have a basic understanding of how syndicated investments work, why they exist, and how you can make money; we encourage you to check out our other content to grow your knowledge base.