Many passive real estate investment opportunities are offered to investors through a vehicle known as a “syndication’. Using a term like “syndication” can make the investment process seem intimidating, as few first-time investors understand what syndications are and how they operate.
Syndications are actually relatively straightforward. The person raising the capital for the deal, known as the sponsor, pools capital from individual investors. Once they have raised enough money, that capital is collectively invested in a deal alongside the sponsor’s own equity investment.
Think of it like buying an airline ticket. Each individual pays for their own ticket. The tickets can range in value. Some people buy more than one ticket. Collectively, the proceeds from the ticket sales are used to pay for the trip. Real estate syndications are similar.
In this article, we explore how real estate syndications work in practice. Read on to learn more.
What is a Real Estate Syndication?
As noted above, a real estate syndication is simply a vehicle used to pool capital from various individuals to then collectively invested into a real estate deal. Syndications are a great option for those interested in truly passive real estate investments, as once their money is invested, there is nothing else for the investor to do.
Syndications can be as simple as two people investing together. Others can be much more complex, with dozens if not hundreds of people investing in a specific deal or real estate fund.
Why Real Estate Syndications Have Become so Popular
Real estate investments, once considered an alternative asset class, have become more mainstream in recent years. Investors looking to diversify away from traditional stocks and bonds are starting to invest in real estate. Real estate offers many benefits, ranging from steady cash flow to investment stability. Because real estate assets cannot be as easily traded like other securities, real estate values are less likely to experience the volatility one might experience with the stock market. During periods of economic uncertainty, like that brought on by the Covid-19 pandemic, real estate becoming increasingly attractive.
That said, even the most sophisticated investors are sometimes at a loss with how to start investing in multifamily properties. Some of the best, most lucrative deals are usually only accessible to the upper echelon, including institutional investors and large private equity investment firms.
Given the high barriers to entry, many investors are now participating in syndication real estate. With this type of multifamily investing, a sponsor identifies a deal and then pools capital from multiple people to use as the equity investment in that deal. The sponsor then oversees the deal on behalf of the investors, who are otherwise passive limited partners.
The Benefits of Real Estate Syndications
There are many benefits associated with investing in a real estate syndication. For one, real estate syndications allow investors to “set it and forget it,” leaving all day-to-day activities to the sponsor overseeing the deal. The sponsor, considered the active partner, owns all responsibilities associated with multifamily investing – ranging from acquisition to permitting, design, financing, construction, lease-up, and eventually, refinancing or disposition of the property.
Another reason investors are drawn to syndication real estate is that they may not have sufficient capital to invest in multifamily property on their own. They might only have $100,000 to invest, for example, which may not be enough to acquire, renovate and stabilize a property. This is a prime example of when the syndication’s partnership model works particularly well.
Syndications also open the doors to deals that individual investors could not access on their own. For example, a sponsor might create a $50 million fund for investing in multifamily properties. With leverage, this might equate to three deals collectively worth $200 million. An individual investor typically cannot access deals of this scale on their own. Investing in a syndication real estate is a way to access deals that are historically only available to institutions, pension funds, family offices, and the like. With a smaller yet still substantial investment of say, $100,000, an individual can participate in the fund and reap the benefits that come with investing in multifamily properties of this scale. In short, pooling money through a multifamily real estate syndication allows people to invest in larger, often more lucrative deals.
Investors are also drawn to syndications as a way of mitigating risk. Rather than making one large investment in a single deal, syndications create opportunities for investors to invest smaller denominations in multiple deals. This approach allows people to spread their risk across projects, product types, and geographical locations.
The Key Parties Involved in a Real Estate Syndication
There are generally two key parties involved in a real estate syndication: the syndicator (often referred to as the “sponsor” or “developer”) and the investors.
The sponsor can be an individual or company and is responsible for all day-to-day activities related to the multifamily investment opportunity. This includes crafting the business plan and then executing that strategy. The sponsor’s responsibilities include researching and evaluating various multifamily properties, property acquisition, planning and design, permitting, financing, overseeing construction, marketing, and lease-up. The sponsor will usher the multifamily deal through to completion, which may be refinancing or selling the property, depending on the syndication’s exit strategy.
With syndication real estate, sponsors will usually have an equity stake in the deal themselves. This is a way of ensuring that the sponsor and investors’ interests are aligned. The sponsor may also collect various development fees along the way, as well as a share of the profits that are not usually not paid out until the investors have earned a certain degree of return first.
The other party to a real estate syndication, as we alluded to above, are the investors. The investors are considered “limited partners” (LP) and have a passive role in the syndication. After contributing their capital, the LP investors generally do not have any responsibilities related to the deal, and therefore, are given few opportunities to influence the decision-making related to the deal. Therefore, it is critically important for investors to carefully vet sponsors before passively investing in a syndication to ensure they are comfortable with the sponsor’s business plan and confident that the sponsor will be able to execute that plan accordingly.
How to Earn Money by Investing in Real Estate Syndications
The distribution of profits from a real estate syndication can be structured in many ways. This structure is often referred to as the deal’s “waterfall.” The term “waterfall” stems from the idea that cash flow from investing in multifamily properties will flow through to investors, pooling at different points, and after that pool is full, the profits then spill over to the next pool of investors in a tiered fashion.
In most equity waterfalls, a syndication’s profits are split unevenly amongst the partners. The sponsor, for example, may earn a disproportionately larger share of the profits if the project beats expectations. That extra slice of the pie is referred to as the “promote.” Promotes are used as a bonus to incentivize the sponsor to deliver results beyond those expected when investing in multifamily properties.
Equity waterfalls can be very nuanced and as mentioned, can vary from deal to deal.
That said, you can expect a waterfall structure to look something like this:
Tier I. Return of Capital:
Typically, the first distributions are made to the LP investors to repay their initial capital contribution. This is called the return of capital. The return of capital must be repaid before anyone earns any profits individually.
Tier II. Preferred Return:
The next bout of cash flow goes to the LPs in the form of a preferred return on their investment. When investing in multifamily properties, the preferred return is often in the 8-10% range. The rate is often called a “hurdle rate” since it is the hurdle the sponsor much overcome before earning any profits themselves.
Tier III. Catch-Up:
A waterfall will sometimes have what is known as a “catch-up” provision, in which case all distributions from investing in multifamily properties go to the sponsor until they achieve a certain percentage of the profits themselves, usually aligned with the LPs preferred return.
Tier IV. Carried Interest:
At this level, remaining profits from the syndication real estate are split between the sponsor and the LP investors based on a predetermined allocation. Returns do not have to be split evenly between the sponsor and LPs at this point. The sponsor may collect an oversized share of the multifamily investing profits relative to their equity investment in exchange for managing the deal.
It is common for sponsors to collect other fees in addition to earning their share of the cash flow distributions or sales proceeds. For example, a sponsor might charge a 1% acquisition fee and/or a 5-10% development fee in exchange for finding, managing and investing in multifamily properties.
Questions to Ask Before Investing in a Real Estate Syndication
Investors will always want to do their due diligence on a sponsor prior to investing in a syndication. When vetting a sponsor, ask several questions including:
- How much experience does the sponsor have in the local market and with that asset class? How many deals have they done that are similar to the one you are considering?
- Does the sponsor spearhead syndications for a living, or does this appear to be their first attempt or a new hobby for them?
- What is the reputation like of each of the sponsor’s general partners? Are they well-known and respected in the marketplace?
- Who else does the sponsor have on their team, either internally or their third-party contractors? What is each person or group’s role and responsibility? How will these players all interact to ensure seamless execution of the deal?
- How have the sponsor’s previous deals performed? Have they met (or exceeded) investors’ expectations?
- How has the sponsor managed through periods of economic uncertainty, such as recessions or changes to the regulatory environment? How have their deals performed in situations like these?
- What sort of fees does the sponsor charge, and are those consistent with what you are seeing elsewhere in the marketplace?
In addition to vetting the sponsor, you will also want to evaluate the deal prior to investing. To the extent you are able, fact check what the sponsor is telling you about the local market, rents, ability to reposition the property, and more. A thorough due diligence process can be a good safeguard for investors looking to invest in a syndication, especially if investing with a sponsor for the first time.
Passive real estate investing is certainly not without its risk. The multifamily real estate market always ebbs and flows, but the illiquid nature of the industry lends itself to being more stable than the stock or other equity markets. Those looking to hedge against market volatility will find multifamily investing to be an excellent option.
And real estate syndications are a great way to get started.
The key to successfully investing in multifamily properties through syndication real estate is to find a trusted sponsor; a person or company that has robust experience and superior market-know how. Look for a team who has a proven track record with multifamily investing.
If you are interested in syndication real estate, contact us today. We would welcome the opportunity to walk you through our approach to investing in multifamily properties, and how you can reap the benefits by passively investing with us today.