Real estate syndication is a primary method by which real estate entrepreneurs fund their real estate projects. It is vital to understand this concept of real estate finance because, as a new investor, this will likely be your go-to method of raising capital. At its core, a syndicated real estate transaction involves bringing a group of investors together to pool capital for investment in real estate.
What does syndication mean?
A real estate syndication is an aggregation of capital from multiple participants to invest jointly in real estate opportunities. Put simply, a syndication means that a group of people come together to make the purchase of a property happen. A syndication may be formed to acquire one property or several properties. Generally, when speaking of syndication, we are referring to the aggregation of equity required to purchase a property. This is the only form of syndication we will cover in this article.
Who are the players?
The sponsor is the owner or developer of the asset; the party who raises the funds – also known as the principal. The sponsor is the party that sources (finds) the deal and executes the purchase and operation of the property. The sponsor must put forth some capital, as investors want to see that the sponsor has some skin in the game, but the sponsor contributes more sweat equity than capital. Most importantly, the sponsor carries out the day-to-day operations of the asset and ensures that the business plan is executed. This party is seeking investors to provide additional capital so that he can gain access to larger real estate opportunities than he would otherwise be able to afford. In exchange for their contributions, investors receive a membership or ownership in the company and a preferred return on their investment.
Investors invest their money in the transaction. There could be one investor or many investors. They generally play no role in the acquisition or operation of the asset; however, they generally will not provide strategic input to the sponsor. Compared to most angel or VC investments, where the investors generally have a fairly active role in the direction or operation of the business, in real estate syndications, the investors play a much more passive role. Investors in real estate transactions are only sought for their capital contribution; the sponsor is generally not seeking advice or input from the investors. You could say that investors are the money guys and gals who want to invest fairly passively in the real estate. They provide the vast majority of the equity.
Who can invest in a syndication?
I’m not going to go into the details of federal and state securities law in this article. There are, however, a few things that sponsors and investors need to know. If you’d like to learn more, just google “Reg D.” Reg D allows companies to raise unlimited funds from accredited investors, and up to 35 non-accredited but sophisticated investors. Accredited investors are defined by having a net worth of over $1 million excluding their primary residence, or an income of over $200,000 if filing as an individual or over $300,000 if filing jointly. A sophisticated investor is someone who is believed to be knowledgeable with business and financial matters but does not meet the requirements to become accredited. More than likely, as the sponsor of the deal, you will most likely be looking for accredited investors.
How to create a syndication?
The sponsor must create documents for the syndication. Seek out a real estate attorney with experience structuring similar arrangements. The sponsor’s attorney must write up a Private Placement Memorandum (PPM). A PPM is a securities disclosure document used to detail to investors the details of the private real estate offering.
How are they structured?
From a business entity standpoint, a single transaction is generally structured using and LLC. This is done because of the ease and low cost of formation. Additionally, LLC’s can have multiple owners and as a pass-through entity the LLC is not a separate tax entity like a corporation. In the case where multiple transactions are involved, a Limited Partnership is the primary structure. In and LP, the sponsor serves is the general partner (GP) and the investors serve as limited partners (LP’s).
Real estate syndication types
There exist several types of real estate syndications. The two most common are the specific offering and the blind pool. In a specific offering the sponsor identifies one or more specific assets to be acquired and raises the capital necessary to carry out acquisition and operation of the asset(s). In this case, the investors are intimately aware of the specific asset or assets being managed. This is the most common type of syndication, especially for sponsors who are relatively new to the game. The second most common type of syndication is the blind pool. In a blind pool the sponsor presents a business plan to investors, explaining how she will acquire and operate properties. The sponsor does not identify the specific properties. Investors make their investment decision primarily on the business plan and track record of the sponsor. In order to run a blind pool a sponsor must have a strong background and proof of performance, otherwise she will struggle to raise capital.
What are the risks?
Risks to the Sponsor: The sponsor generally will be exposed to significant financial and reputational risk. Oftentimes, the sponsor will have personal recourse guarantees on the acquisition loan. Should the property end up underwater due to a market decline, the sponsor could be in a very tough situation. The sponsor also puts his or her reputation on the line. Unlike the world of tech startups, a real estate entrepreneur can’t iterate or pivot to quickly turn things around. One bad move and the sponsors’ reputation and ability to raise capital in the future could be on the line.
Risks to the Investor: The investor will also incur significant financial risk as they are providing the majority of the capital. They have marginal reputational risk, generally they will not be marketing the deal and the asset.
Additionally, as with any real estate investment, there is no sure thing. There are inherent risks on the front end, with regard to the acquisition or development of the asset. There can also be budget shortfalls or operating deficits, lease terminations and vacancy, tenant bankruptcies and turns in the market. Despite the sponsors best predictions, there is no guarantee in real estate.
At the end of the day, the primary motivation for both the sponsor and investor are the financial rewards associated with their participation. The parties join together to earn a profit. The sponsor is compensated by collecting fees for the work and services performed throughout the transaction as well as profits on the back end. The investors get cash flow and back end profits.
The rewards should be commensurate with the risks taken and the value added. The fees and disbursements should reflect the risks and value added by each party. There is no typical way to do it and the structure varies drastically across product types, geographic areas etc. Keep in mind, whether you are the investor or the sponsor, the structure is totally negotiable; however, I’ve outlined the common fees below.
Equity investors will earn disbursements periodically during operations (quarterly or annually, sometimes monthly). The sponsor will distribute disbursements to investors pro rata, in accordance with their respective interests in the deal. Typically investors receive a preferred return between 6-10% of the initial money invested, 8% being the most common. The preferred return is the benchmark payment distributed to all of the investors.
Think About Incentives Behavioral Economics
As an economics/psychology guy, I think it’s always prudent to consider incentives and motivations. When considering such factors in a real estate syndication, one must consider how to motivate the sponsor. The sponsor is ultimately responsible for the success and outcome of the deal. Therefore, it is prudent to consider how to motivate the sponsor to perform at the highest level. Suppose a sponsor puts in 10% and receives 10% out. How much more motivated would a sponsor be if she put in 10% but received 25% of the proceeds? We can assume that if given proportionally more of the proceeds, then she will likely perform better. This could potentially provide for a safer outcome for the investors and likely a bigger pie for everyone.
When the sponsor exits the property by selling the asset, back-end profits are split between the investors and the sponsor. The disbursement of the proceeds occurs in the following sequence:
- Return of capital to investors – return their original equity investment
- Preferred return to investors (6-10%)
- Accruals – fees that need to be paid
- Sponsor/Investor split. After everything due has been paid, the investors/sponsor split the rest according to the remainder of the profit. Generally, the sponsor receives 20%-30% and the investors receive 70%-80%. An equity waterfall is the most common pattern of disbursement.
When everything has been paid, and profits still remain, the most common method of disbursing such funds is through an “investment waterfall” schedule. This is a multiple tier split mechanism that shifts the payout to the sponsor as her performance increases. As we noted earlier, it is beneficial for everyone if the sponsor is paid more for superior performance. Equity waterfalls add complexity and should be avoided by new real estate sponsors. I believe that sponsors should seek to simplify the returns structure, as a complex structure that only an geeky MBA can understand, will drive many potential investors away from the deal.