The term “syndication” makes the term “real estate syndication” seem more complicated than it really is. Think of it like buying an airline ticket. Anyone who has purchased an airline ticket has participated in syndication. Each ticket sold goes toward funding the flight. Some people might pay more or less than others for their tickets. Some people might buy more than one ticket. Yet collectively, the proceeds from the ticket sales are used to pay for the trip.
Real estate syndication is no different. Investors pool their capital to, collectively, invest with a sponsor in a real estate syndication.
Syndications are becoming more popular than ever. That’s because commercial real estate, once considered an alternative investment, is starting to enter the mainstream. Investors, large and small alike, are starting to see the benefit of adding commercial real estate to their portfolios. Commercial real estate, for example, continues to prove resilient even in the wake of widespread economic uncertainties. Given the illiquid nature of commercial real estate (i.e., it is not as easily purchased and sold as other commodities, like stocks and bonds), it is not as prone to market volatility.
That said, even the most sophisticated investors are sometimes at a loss with how to start investing in commercial real estate. 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 barrier to entry, many investors are now participating in real estate syndications. With this type of 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. In this article, we take a deeper look into the mechanics of real estate syndications, including the roles and responsibilities of each party and how profits are generally distributed. Read on to learn more.
What is Real Estate Syndication?
Real estate syndications are a way of pooling capital from various individuals to then, collectively, invest in a real estate asset. Syndications are generally a great vehicle for those who cannot or do not want to buy an investment property outright on their own – also known as passive investing.
As was the case with the airline ticket example above, real estate syndications function in a similar manner.
Several individuals invest in the syndicate, and then the manager of the syndicate (known as the “sponsor”) will then leverage those funds to invest in a real estate deal. Syndications are the original form of real estate “crowdfunding,” a term that only grew in popularity with the advent of online crowdfunding platforms like CrowdStreet and RealtyMogul.
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.
Related: Become an Investor
Why Do Investors Participate in Real Estate Syndication?
There are several reasons why investors participate in real estate syndications. As noted above, one of those reasons is when someone does not want to or cannot afford to purchase a property directly.
Even if they could purchase a real asset individually, some people prefer being passive investors and don’t want to deal with the day-to-day responsibilities of managing real estate. Passively investing in real estate is a way 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 ranging from acquisition to permitting, design, financing, construction, lease-up, and eventually, disposition.
In other circumstances, someone simply may not have sufficient capital to purchase an investment 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 to invest in three separate value-add multifamily deals. 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 real estate syndication 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, $500,000, an individual can participate in the fund and reap the benefits that come with investing in deals of this scale. In short, pooling money through 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.
Who is Involved in Real Estate Syndication?
There are generally two key parties to a real estate syndication: the syndicator (typically referred to as the “sponsor” or “developer”) and the investors.
Investors, large and small alike, are
starting to see the benefit
of adding commercial real estate to their portfolios.
The sponsor can be an individual or company and is responsible for all day-to-day activities related to the deal. This includes crafting the business plan and then executing that strategy. The sponsor’s responsibilities include researching and evaluating various opportunities, property acquisition, planning, and design, permitting, financing, overseeing construction, marketing and lease-up. The sponsor will usher the deal through to completion, which may be refinancing or selling the property, depending on the desired exit strategy.
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 investing, to ensure they are comfortable with the sponsor’s business plan and confident that the sponsor will be able to execute that plan accordingly.
Would you like to learn more about the costs and benefits that come with real estate syndication? Check out Smartland today to find out more.
Choosing Your Role in Real Estate Syndication
The roles and responsibilities associated with being a sponsor and an LP investor are dramatically different. Determining which role is best for you depends largely on whether you want to be an active or passive real estate investor.
A sponsor is truly an active investor. Sponsors are responsible for overseeing every detail associated with the deal, from start to finish, and every step along the way. This requires a major commitment and usually equates to being someone’s full-time job. This is particularly true as you begin to look at larger and more complicated deals, especially deals that involve ground-up development or significant value-add investments. In situations like these, it is critically important that the sponsor has sufficient knowledge and experience to execute properly.
LP investors, on the other hand, are passive investors who get to enjoy the fruits of the sponsor’s labor without taking on as much personal risk or responsibility. Those who invest in syndication are entrusting the sponsor with their capital and then allowing the sponsor to deploy that capital efficiently and in accordance with the syndication’s business plan. LP investors essentially take a backseat role, with the sponsor reporting back to them on a regular basis to give an update as to how the deal is progressing.
Related: Smartland: About Us
What Are Some Ways to Split The Profit in Real Estate Syndication?
The distribution of a syndication’s profit 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 commercial real estate projects 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.
1. Raise Capital
The first job for the sponsor overseeing a syndication is to raise the capital needed to acquire the property. Most banks will expect the syndication to invest at least 30-40% of equity.
2. Acquire Single Asset
Once the syndicator has raised sufficient capital, they will move forward with closing on (i.e., purchasing) the asset.
3. Improve Asset
After closing, the syndicator will begin to make both physical and/or operational improvements to the asset to help stabilize the property.
4. Increase NOI
Improving the asset will boost the property’s net operating income (NOI), which is directly related to a property’s end value.
5. Preferred Distribution
Once a property is generating cash flow, investors will earn a “preferred distribution,” which are payments investors earn before the syndicator begins collecting their profits.
The exit strategy is a critical piece of the business plan and may include stabilization and then refinance or sale of the property.
7. Final Distribution
The syndication closes out after final distributions have been made to investors, which may include a lump-sum payment based upon the final value of the asset upon refinance or sale.
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.
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. Preferred Return: Typically, the first capital paid out of cash flow goes to the LPs in the form of a preferred return on their investment. This preferred return is most common 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 II. Return of Capital: Once the preferred returns have been paid to LPs, 100% of cash flow distributions go straight to repay investors the capital that they originally contributed.
Tier III. Catch-Up: A waterfall will sometimes have what is known as a "catch-up" provision, in which case all distributions at this point 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, the remaining profits 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 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 and managing the deal, respectively.
What to Be Cautious About During Real Estate Syndication?
Investors will always want to do their due diligence on sponsors prior to investing in syndication. When vetting a sponsor, be sure to ask several questions such as:
- 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 syndication, especially if investing with a sponsor for the first time.
Final Thoughts on Real Estate Syndication
Investing in commercial real estate is certainly not without its risks. The commercial real estate market will always experience ebbs and flows, but the illiquid nature of commercial real estate lends itself to being more stable than the stock or other equity markets, which can experience wild swings—even on a daily basis. As such, those looking to hedge against market volatility will find commercial real estate to be an excellent option.
Given the high barrier to entry many investors are now participating in real estate syndications.
And real estate syndication is a great way to get started.
The key to successfully investing in real estate syndications is to find a trusted sponsor; a company that has robust experience and superior market know-how.
At Smartland, we have had a long history of successful real estate investing. Our partners began by investing in single-family homes, which we then renovated, rented, and either flipped for a profit or held for long-term yield. We have done this thousands of times, refining our business model and processes along the way. We have used this experience to scale up, and today, raise money for larger value-add apartment and ground-up development deals. Most recently, we purchased a 160-unit apartment community that we will renovate, reposition, and then refinance in order to repay our investors, returning to them their capital and yet leaving them in the deals to earn passive income with us. These are true real estate partnerships.
If you are interested in investing in syndication, contact us at Smartland today. We would welcome the opportunity to walk you through Smartland’s business model, redevelopment strategies, and current market focus.