Syndication in Commercial Real Estate

Real Estate Syndication: What You Need to Know

Real estate syndication is the process in which multiple investors pool their money together to purchase a commercial property. Syndication is similar to crowdfunding, and many real estate syndication deals are now crowdfunded on the internet, through platforms such as Fundrise, Realty Mogul, and a variety of others. Investors in a real estate syndication deal benefit by getting access to deals they would not be able to create on their own, as well as by not having to worry about the day-to-day hassles of personally owning investment property (i.e. property management).

Real estate syndication deals are usually structured as either limited liability companies (LLCs), or limited partnerships (LPs), with the sponsor being the general partner (GP), and each investor participating as a limited partner (LP). A sponsor typically invests somewhere between 5% and 15% of the equity into a real estate project, while the investors typically place 85% to 95% of the equity into the project.

In some cases, a syndication deal is set up as a joint venture(JV), in which a third equity partner helps gather investors for the sponsor. In many cases, this JV partner will also help with other responsibilities, such as tax reporting.

How Profits are Distributed in a Real Estate Syndication Deal

Both the investors (LPs) and the sponsor (GP) receive profits from a real estate syndication in multiple ways. Rental profits are typically distributed on a monthly or quarterly basis, depending on the exact nature of the syndication agreement.

Overall, deals can last anywhere between 6 months and 10+ years, though this is typically determined at the beginning of the deal. Deals end when a property is sold and the investors get their money back, plus a certain amount of the profits. Specifically, the LP investors need to achieve what’s called a preferred return, which averages about 8%, before the investors can receive carried interest, an additional share of the profits.

For instance, if an investment achieves a return of 12%, and the preferred return is 8%, both the LP investors and the GP sponsor will get the same amount of return, up to 8%. However, the GP may be entitled to a larger percent of the profits, say, 25%, for all profits above 8%. This is called a hurdle, and in some cases, a deal may have multiple hurdles. For instance, in the example deal above, there could be a second hurdle of 20%, and the GP might get 50% of all profits above that 20% return. This method of profit distribution is often referred to as a waterfall structure.

Let’s take the example of a property sale at the end of a 1-year syndication deal. When purchased, the property was initially valued at $700,000, and now, one year later, is being sold for $1,000,000, for a $300,000 profit (a 30% return). The GP placed 10% equity in the property, or $70,000, while the remaining investors placed 90% equity in the property, or $630,000. If the preferred return is 8%, and the GP receives a 25% share of profits above that amount, the GP will receive a 25% share of all profits over $56,000.

In this case, the GP will receive an 8% share of profits up to 8%, equaling $4,480, and a 25% share of the remaining $244,000, equalling $61,000. In the end, this means that the GP will receive $65,480, or a 93.5% return, while the LPs will receive a total of $234,520, or a 37.2% return. It should also be stated that a sponsor/syndicator will generally receive a disposition fee of around 1% of the sale price when the property is sold, which, in this case, would add an additional $10,000 to the sponsor’s profit, slightly changing the percentages mentioned above.

Of course, this example is somewhat exaggerated, as a 30% property appreciation in 1 year is quite unlikely. In addition, we don’t include tax liabilities, or the impact that a commercial loan would have on the investment-- as the vast majority of syndication deals are done with debt. Finally, it’s important to realize that in longer deals, returns are typically calculated via IRR (internal rate of return), which incorporates the concept of time value of money (TVM).

Commercial Real Estate Loans and Syndication Deals

For LP investors and sponsors, choosing the right type of commercial financing for a deal is of paramount importance. In many cases, syndications that will last more than a year or two (as most do) will benefit from fixed-rate financing, as this makes financial forecasting significantly easier. In addition, looking at the loan term is also essential, especially for investors. If the loan will need to be refinanced before the syndication period is over, the deal becomes significantly riskier.

For example, if a 10-year syndication deal is being funded with a 5-year loan, potential investors may be correct in worrying about what will happen if the property cannot be refinanced on reasonable terms after the 5-year period. In contrast, if a 5-year deal is being financed with a 10-year loan, investors have much less to worry about, though they will generally want to factor in any loan prepayment costs into their calculation of potential returns.

Whether a loan is non-recourse also factors in the process. The vast majority of sophisticated sponsors prefer non-recourse debt, as it insulates their personal assets from being repossessed by a lender in the case of a loan default. For LP investors, this is somewhat less of a concern, as limited partners are not generally liable for business debts. However, LP investors should be somewhat wary of working with a sponsor whose credit score or net worth is not high enough to secure non-recourse debt.

Due Diligence for Investors

For an investor looking at a syndication deal, upfront research is key. It’s easy to turn down a deal without any commitment, but once the papers are signed and the money is handed over, it can be very difficult to get out of one. Potential investors are generally provided a detailed rent roll, and a pro forma operating statement, which should be both looked at carefully and with a highly critical eye. In addition, investors should look at occupancy rates for the property when compared to other, similar properties in the area.

If current occupancy rates are negatively impacted by temporary factors (like major renovations), investors may be able to look at historical data. While historical data will not be available for newly constructucted properties still in the lease-up phase, investors can still do general economic research in the area in an attempt to gauge potential tenant demand. In addition, investors should try to track down previous investors who have worked with the individual or group that is currently sponsoring the deal. This way, they can be apprised of any potential issues before deciding to make a final decision.

Internet Crowdfunding, the JOBS Act and Real Estate Syndication

While the concept of real estate syndication has been around for a long time, changes in recent years have made it significantly more accessible to ordinary investors. Two of the most significant shifts have involved the passage of the Jumpstart Our Business Startups (JOBS) Act of 2012, and the advent of internet crowdfunding.

First however, it may be beneficial to take a moment to discuss the history of real estate syndication deals. Due to the Securities Act of 1933, all new securities offerings (such as real estate syndications) needed to be registered with the Securities and Exchange Commission (SEC). However, rules in the Act allowed syndicators to avoid registering investments, as long as they avoided public solicitation. Hence, for most of the last 90 or so years, nearly all syndications have been private deals. In addition, federal securities laws limited most syndications to accredited investors. To clarify, an accredited investor is one who has a minimum net worth of $1 million (not including the investor’s primary residence), and has had an income of at least $200,000 for the last two years (or $300,000 for married couples). Accredited investors are generally allowed to place their money in riskier investments than unaccredited investors.

However, the JOBS Act of 2012 changed all this by allowing syndicators to advertise to the public, and allowing unaccredited investors to invest more easily in syndications. Despite this, there are still certain limits on the amount that unaccredited investors can invest. Specifically, investors with an income or net worth up to $100,000 can invest $2,000 or 5% of their annual income (whichever is more) in a private investment, and investors with an income or net worth of more than $100,000 can invest the lessor of $10,000 or 10% of their annual income.

Online crowdfunding takes advantage of this newly open economic environment by allowing syndicators to solicit investors and share the details of potential investments online. There are both upsides and downsides to this; unfortunately, the sheer number of syndicators and services online can be daunting, and can make it easier for unethical individuals and companies to solicit investors for sub-par or fraudulent deals. However, the fact that deal information is out in the open means that investors have the ability to compare multiple deals from different sources. Plus, they can also get expert advice from others in the industry on whether a deal is legitimate, or simply too good to be true.

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