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February 5, 2019
Making a career out of investing in real estate is not exactly the easiest thing. Like a lot of investments, real estate investments tend to start out small before progressing into something bigger. However, this progression could take years and for the ambitious real estate investor, the idea of spending years of their career investing in turnkey rental properties doesn’t seem too appealing. Fortunately, real estate investors can gain the financial momentum to fast track their career via a concept known as real estate syndication For real estate investors looking to learn more about real estate syndication, this article will provide a complete guide to the concept to help them broaden their knowledge.
What is Real Syndication?
In the simplest sense, real estate syndication also recently known as real estate crowdfunding is the consolidation of financial resources from property investors primarily for the purpose of financing a property investment. This financing could be used to either purchase a property in its entirety or as a contribution of equity to fund the construction of a property.
The number of property investors involved in syndicate can vary from a few to hundreds and a syndicate may be formed for the sake of acquiring a single property or to invest in several real estate opportunities. The goal of real estate syndication is not just to make profits. The investors also have access to more funds meaning more buying which would allow the real estate investors in a syndicate to invest in and manage larger scale investments that would have probably not been available to them as individual investors.
Real estate investors must ensure that they have the necessary qualifications required to join a syndicate. Several real estate syndications are structured under one of two SEC Regulation D;
According to exemption 506 (b), for real estate syndications with up to 35 persons in one deal, the investor must be sophisticated such means that investors must possess satisfactory financial education. Also, under this exemption, sponsors can only raise funds from an already existing client base. As such, if a real estate investor is interested in a deal in any syndication, they must first of all establish a relationship with the sponsor. Signing up on the sponsor’s website is a good way to start this relationship.
According to exemption 506 (c), investors in real estate syndications must be accredited. For an investor to become accredited, he or she must meet at least one of the following requirements;
How Does a Real Estate Syndication Work?
Before one can understand how real estate syndication works, he or she must first of all know about the parties involved and their role in a syndication deal. With that said, in every real estate syndication, there are two main parties – the sponsors and the investors. Below is a breakdown of how each party is involved in the real estate investment:
The sponsor is the developer of the property of interest. As the work horse, the sponsor is perhaps the most important party in the syndicate. As a matter of fact, the success of a real estate syndication is largely dependent on the competence of the sponsor in carrying out their tasks. The responsibilities of the sponsor in a real estate syndicate include;
In addition to all of time investment which is often referred to as “sweat equity,” the sponsor are also expected to make financial investments. The financial equity of the sponsoris usually an amount between 5 to 20 percent of the total equity. This goes to show that the sponsor has a stake to lose in the project to guarantee the investors of their contributions.
The Real Estate Investor
The investor also called the limited partner like the name suggests is mainly responsible for investing money. There could be as many investors as possible in a syndicate and they can contribute as much as 95 percent of the total capital for the investment. Unlike the sponsors who also contribute sweat equity, they investors do not play a role either in the acquisition of the asset or in the execution of the business plan.
Essentially, investors play a very passive role in real estate syndication and are mainly sought after for their financial contribution. In most cases, the sponsor may not even require their strategic input for day-to-day operations. In certain cases however, the investors have limited decision making power to minimize their liability.
Now here is a step by step guide to how real estate syndication works;
This first step in any real estate syndication is to choose a market. High growth metropolis with a good population are usually the target markets. Factors like rent growth rate will also be considered when choosing a market.
Next, the sponsor will identify a suitable and stabilized property from the chosen market. A good property should be stabilized, conservatively underwritten and capable of delivering value added opportunities. After a property is pin pointed, the sponsor will then proceed to create a syndication and raise capital from investors to fund the purchase (renovations or down payments included) of the asset.
The third step of a real estate syndication is the implementation of the business plan. This is between the sponsor and the property management group. The primary aim of every business plan is to add value to the real estate property usually by increasing its net operating income (NOI). This can be effected through renovations and rebranding.
Like earlier stated, a syndicate can be formed for the acquisition of a single property or several properties. After a successful implementation of the business plan, the parties can either choose to hold or exit the syndicate.
How does one Make Profits from Real Estate Syndication?
The essence of real estate syndication is for every member to make profits at the end. Now how can one make profit from a syndication? Below are the ways the three parties in real estate syndication make money.
The sponsor has three sources of income in a syndication – equity participation, acquisition fees and asset management fees.
The investors contribute a vast majority of the financial equity and as such will receive a greater deal of the revenue amassed from the sale or operations of the real estate property. The amount an investor gets will be dependent on their percentage ownership and the payment structure used by the sponsor.
To illustrate, here’s how the payment structure is a real estate syndication works;
Assume a real estate syndication wants to acquire a property worth $5 million USD all in cash. The sponsor in this case secures the total amount needed to finance the purchase as well as the acquisition fees all from the investors and then the deal is structured and closed. Now, after a year of operations, with the fees and expenses settled, the property generates a total of $600,000 in profit, say from rental payments. The investors in the syndication will first of all receive a preferred return on investment from the profits. Assuming the predetermined rate of return was 10 percent, that would be 10% of $5M, meaning the investors would get $500,000 out of the $600,000.
The $100,000 left of the profits after the investors must have gotten their preferred returns will then be split between the sponsor and the investors at a predetermined percentage. Assuming the agreed upon percentage was a 70% – 30%, with the investors getting the bigger share, in this case, the sponsor would get $30,000 while the investors get the $70,000. Overall, the investors get a total of $570,000 while the sponsor makes $30,000.This situation is undoubtedly very profitable to both parties, the investors get to make more money than they would made as individual investors and the sponsor gets to make money from the fees and equity participation with little to no financial contribution. Also in the event where the property appreciates in the future,they can still enjoy the equity percentage appreciation of the asset.
Factors to Consider When Evaluating Real Estate Syndications
There are certain things a real estate investor needs to look out for before joining a real estate syndication to ensure that they make well informed and successful investments choices. Some of the important factors to evaluate in every real estate syndication include;
Real estate investors are the silent party in syndications. Other than their contributions, investors really have little to no control over the management of the property. As such it is absolutely vital to ensure that the sponsor in a syndication is a trustworthy and credible party that is also very knowledgeable about the asset class they want to invest in. Good sponsors will also provide periodic reports on the status and management of the property.
Properties generate revenue and the investors are due a return on investment. This return can be paid based on the initial investment of the investor or as a predetermined percentage of the gross revenue receive. Real estate investors should ensure that the structure of the preferred return to investors of a real estate syndication is a structure that is ideal for them.
As aforementioned, the sponsors in a syndication earn money through acquisition fees, asset management fees and equity participation. The value of these fees will vary depending on the deal, nevertheless, the percentage should be reasonable enough to keep the sponsor motivated all through the period of managing the property. Remember, the sponsor is the work horse of the syndicate and the more time and effort they invest, the better the chances of maximizing returns.
Every real estate syndication should have an exit plan and it is the responsibility of the sponsor to draw out an exit plan. Exit plans typically have a projected number of years of hold and the time frame is largely dependent on the type of property in the syndication. For example stabilized properties tend to have longer deals because of the potential of equity build up and rent growth, while value added properties favour shorter deals as value is realized from the properties in its early years
It is important for real estate investors to understand the concept of real estate syndication. It is essential because this is usually the go-to method of raising capital for a lot of investors looking to advance their real estate careers and having the basic knowledge of how real estate syndications function will enable one make better investment choices.
Bryan M. Chavis