What is Real Estate Syndication?
In simple terms, real estate syndication is the pooling of financial and intellectual resources for buying large real estate deals that generate economies of scale.
A real estate syndication has two main players: 1) General Partner, and 2) Limited Partners.
The main pilot of a syndication is called general partner. The general partner brings on board investors who are also called limited partners.
While the general partner is responsible for operations, preservation and growth of capital, limited partners have a strictly passive role. Limited partners are typically accredited investors.
This brings us to our first question.
Who is An Accredited Investor?
This is a question that real estate investors often ask us. An accredited investor is:
- An individual or couple with a networth of $1 million or more, excluding their primary residence or,
- Annual salary of $200,000 filing single or $300,000 filing jointly for the past two calendar years and a reasonable expectation to do so going forward.
Who Are the Players Involved in a Real Estate Syndication?
- General Partners (Deal Sponsor and Operator)
- Key Principal
- Passive Investors (also called Limited Partners)
- Property Managers
As you can see, there are many moving parts to a syndication. Every player has a specific, defined role which helps drive project efficiencies and achieve economies of scale.
So, let’s understand the roles of each player in a real estate syndication.
The general partner can act as a deal sponsor as well as an operator. While the deal sponsor is responsible for acquisition and underwriting, the operator is the one with their boots on the ground.
When syndicating a value-add property, the operator plays a significant role in the success of the project. The property manager reports to the operator.
Sometimes, the syndication might be too large to be funded entirely by the deal sponsor. In this scenario, the deal sponsor will get one or more key principals on board. The key principal is a passive player who guarantees the loan and arranges for the necessary funds to get the project going.
Who is Real Estate Syndication For?
Now you have a basic idea how a real estate syndication works. But, how do you know if a real estate syndication is the right investment option for?
These are some of the main reasons why investors participate in a real estate syndication:
- You are a high-paid professional or high net-worth entrepreneur looking for reliable ways to generate better returns
- You are aware of the benefits of investing in real estate. But, you do not have time to actively manage a property
- You are uncomfortable with the volatile nature of the stock market
- You are paying too much in taxes
- You don’t want to put all my money in stock markets and mutual funds. You are more comfortable with a diversified portfolio.
If any of the above situations holds true for you, you should seriously consider investing in a real estate syndication.
What is Multifamily Investing?
In simple terms, multifamily investing involves buying and selling of properties that have more than two units. Multifamily units include duplexes, townhouses and condominiums. You can still get conventional financing on a property that has up to 4 units. But anything over 4 units, you will have to go for commercial financing.
The two main reasons why investors transition from single-family investing to multi-family investing are: 1) Scalability, and 2) Risk mitigation.
Managing a single multi-family property is far easier when compared to managing multiple single-family homes spread out all over the place. Further, because the revenue stream is much larger, it becomes commercially feasible to hire agencies to manage multi-family properties.
The biggest risk of investing in a single family property is that you are relying on a single tenant and a single stream of income. So, if you lose your only tenant, you will have to fork out the entire mortgage payment from your own pocket. However, in a multifamily property, multiple tenants and multiple streams of income alleviate this economic loss to a large extent.
The ticket size for multifamily properties with several hundred units can run into millions of dollars. It is common for investors to syndicate such large deals.
Outlook on Multifamily Investing:
“With multifamily residents spending an average of 25% of income on rent, most markets have headroom to deliver further rent growth”.
~CBRE, 2019 Global Real Estate Market Outlook
Real Estate Syndication SEC Offering Types
If you are planning on participating in a real estate syndication, it is important for you to learn how a syndicate is legally structured.
So, now we know the syndicator is the pilot helming the project. We also know that the syndicator is raising money from interested investors like yourself. By doing so, the syndicator is selling “securities” in the private market.
In simple terms, securities are investment contracts between the general partner and limited partners. These securities need to be registered with the SEC unless exempt. There are numerous ways general partners can avail this exemption.
What is Rule 506 B?
Rule 506 B exemption is, by far, the most popular route for raising capital in a real estate syndication. Let’s talk about the pros of Rule 506 B exemption first.
Advantages of Rule 506 B
The BIGGEST advantage of raising capital under Rule 506 B is that there is no limit on the amount of capital that can be raised. So, Rule 506 B is the go-to option for large deals which require millions of dollars in capital.
Another big advantage of Rule 506 B private exemption is that unlike other exemptions, this rule allows a deal sponsor to raise money from accredited AND non-accredited investors. A deal sponsor can raise money from up to 35 non-accredited investors.
We have already established the benchmarks for an accredited investor. So, under Rules 506 B, a sponsor can raise money from his friends and family who are non-accredited and do not meet these benchmarks.
However, any non-accredited investor should be a “sophisticated investor”. In other words, they should be financially savvy and have a proper understanding of the associated risk.
It is NOT mandatory for a deal sponsor to provide disclosure information if they are raising money solely from accredited investors. However, the SEC mandates that the deal sponsor provide disclosure information via a memorandum offering even if there is a single non-accredited investor on board.
Pro Tip – There are many deal sponsors who shy away from prepping a memorandum offering since it increases the cost and time required to syndicate a deal.
A memorandum offering will give you a thorough understanding about the objectives, risks and terms of investment. We strongly recommend you invest your hard-earned money in a syndication only after studying this information.
Sounds Too Good to Be True…Any Catches?
What the SEC giveth, they taketh away
Lack of Certification Can Lead to Trouble for the Deal Sponsor
As discussed above, Rule 506 B does NOT require a third party like a CPA or attorney to vet the accredited status of an investor. So, there have been instances when an investor misstates his asset and wrongly participates in a syndication as an accredited investor.
Because of this, the deal sponsor might pass the permissible limit of “35 non-accredited investors” and land in the hot soup with the SEC.
General Solicitation in NOT Allowed in Rule 506 B unless….
The SEC does not permit general solicitation when raising money under Rule 506 B. As a deal sponsor, you cannot approach investors via emails, social media, or direct mail unless he/she has a pre-existing relationship.
But, how does a deal sponsor prove a “pre-existing relationship” with an investor?
Sponsors get referrals from their current investors who are earning good returns. Do such referrals considered come under the purview of a “pre-existing relationship”? This is a broad topic that falls outside the scope of this guide. Get in touch with Pancham if you wish to learn more about this topic.
What are the Alternatives to Rule 506 (B) for a Real Estate Syndication?
Apart from raising money under Rule 506 (B), real estate sponsors can also raise money under Rule 506 (c) or Rule 504. The biggest disadvantage of raising money under these exemptions is the cap on the total capital that can be raised (at $10 million and $5 million respectively).
Non-accredited investors are not allowed to participate in a Rule 506 (c) offering. However, unlike Rule 506 (b), there are no restrictions on general solicitation.
SEC requirements mandate that deal sponsors much verify the accredited status of an investor from a broker-dealer, attorney, or CPA.
Understanding Real Estate Markets
Primary Markets, Secondary Markets, and Tertiary Markets
Even if you are new to the real estate market, you must have heard the terms: primary market, secondary market & tertiary market being quoted rather freely.
There are many who make this segmentation simply on the basis of population – which is both rustic and incorrect. William Hughes, senior vice president and managing director, Marcus & Millichap states that this segmentation is dependent on both investment activity AND population.
For instance, with the waning fortunes of car manufacturers, investment activity in Detroit has also shown a major decline. So, Detroit, even with a population of 5 million can be considered a secondary market from a real estate investment perspective.
In contrast, a smaller city like Austin is recording much higher real estate investment activity. Certainly, huge oil reserves and the presence of prominent tech companies has contributed in no small measure to this phenomenon.
Thus, Austin with a population of barely 2 million can be considered a primary market in the real estate investment world.
A common misconception among investors is that overall secondary markets become more attractive when the real estate market heats up.
As per the 2019 report released by Land Urban Institute and PWC,
“International investors are becoming comfortable with some opportunities beyond the primary markets, but do not consider the large number of secondary markets as being equally desirable”.
Having said that, which are some of the secondary markets which are witnessing a spurt in investment activity?
Apart from perennial favorites like San Diego, Boston & Austin, investors are also looking to buy commercial office space in cities like Columbus, Tampa, and Raleigh as well.
Class A, Class B, Class C Multifamily Explained
This is another property classification that every amateur real estate investor MUST understand. So, let’s take it from the top.
These are the cream of the crop. Typically, these are upscale properties built in the last 15 years with little or no deferred maintenance issues. Because these properties are perceived to carry less investment risk, cap rate for these Class A properties is lower compared to Class B and Class C properties. Primarily, these properties are bought with the hope of achieving good appreciation.
A step below Class A properties, Class B Multifamily properties are 10 to 25 years old. These properties are generally well-maintained and unlike Class A properties, include a tenant base that comprises of both blue and white collar workers. Cap rate for Class B properties is higher than Class A because these are viewed as riskier investment propositions. Renovating a Class B property in a Class A area could help prove to be an excellent value add.
Class C properties are more than 30 years old and require significant repairs to generate a steady cashflow. Typically, tenants residing in such Class C properties are low to middle-income level blue-collar workers.
Is Real Estate Crowdfunding a Good Option for you?
Real Estate Crowdfunding is the process of raising funds to finance real estate projects using online or web-based platforms.
Real Estate Crowdfunding has really taken off after the introduction of JOBS Act in 2012. When the JOBS Act was initially introduced, real estate crowdfunding was restricted to accredited investors. However, after 2016, crowdfunding platforms have opened up to non-accredited investors as well.
According to this Ernst & Young report, the global real estate crowdfunding market is estimated at $8 billion in June 2018. Of this, the US contributed the lion’s share at $6 billion.
Much like traditional real estate syndication, real estate crowdfunding can be a good option for you provided you conduct a thorough due diligence:
Vetting a Deal on a Real Estate Crowdsourcing Platform:
- First of all, always use reputed platforms with a proven track record of generating good returns for their investors. Make sure that the platform is backed by solid investors. After all, you do not want to go through a platform that goes under. Do you?
- Don’t be afraid to ask questions. Get in touch with support and learn how the crowdfunding platform vets deals.
- Once you are satisfied with the platform’s reputation, it is time to investigate the deal. The memorandum offering is a good place to start.
- Does the deal sponsor have a good track record? What is the preferred return? Does the sponsor have enough skin in the game? These are some questions that you need to ask before investing your hard-earned money.
Realtymogul and Fundrise are two well-known crowdfunding platforms.Both these platforms have a minimum investment criteria of $5,000.
Real Estate Syndication Returns – What to Expect
A real estate syndication is structured to motivate the deal sponsor to do his best to generate higher returns for his investors.
Once a real estate property starts generating income, passive investors earn what is called a “preferred return”.
Typically, this preferred return is paid out BEFORE a sponsor starts receiving his share of profits. This is called a “true preferred return”.
However, in a “pari-passu preferred return”, the sponsor and the investor are paid out at the same time.An 8% preferred return is the industry norm. Typically, preferred return ranges from 5% to 10%.
Once all investors have been paid their preferred return, the remaining balance is split up between the sponsor and the investors based on the profit split agreement. The industry norm is 70:30 with 70% going to the investors and 30% to the sponsors.
Let’s consider a real estate property with the following financials:
- Amount Balance: $100,000
- Preferred Return Owed @8%: $8,000
- Amount Earned: $10,000
In the above example, the property has earned $10,000 and only $8,000 are owed in preferred returns. The balance $2,000 is split up between the sponsor and the investors. If it’s a 70:30 split, the investors will get an additional $1,400 whereas the sponsor will earn $600.
Any Reasons to AVOID Investing in a Real Estate Syndication?
Real Estate Syndication is not for everyone. These are some of the main reasons why you might NOT want to invest in a real estate syndication:
Real estate syndication is clearly the domain of long-term investors. Typically, you are looking at an investment horizon or “hold period” of 5-7 years. There are some exceptions to this rule, and many sponsors will allow passive investors to sell their stocks to another investor in the syndication, or even to someone outside of the syndication.
Passive investors should read the fine print in the memorandum offering carefully and talk to the syndicator to accurately determine if it is possible to sell their holdings and liquidate their investments at an earlier date.
Big Ticket Investment
This is another stumbling block for many investors. In 2018, a real estate syndication averaged at $3 million. With such a large ticket size, you will be required to fork out thousands of dollars in order to participate.
Clearly, real estate syndication is for those who with a sizeable investment portfolio and a long term investment horizon.
Participating in a Syndication Requires Extra Effort on Your Part
The role of a passive investor is not completely “passive” in nature. There is some initial leg work involved. It is important to conduct a thorough due diligence and vet the sponsor before you invest your hard earned money. So, if you are not willing to go this extra mile, real estate syndication is not for you.
You Don’t Like to Relinquish Control
If you are a control freak who has trouble trusting other people, real estate syndication is probably not for you.
As a single family investor, you are running the whole show- from property acquisition to negotiating a mortgage to fixing a running toilet. Whereas, as a limited partner in a real estate syndication, you will be relegated to the role of a backseat driver.