Summary: In this article you’ll learn how to invest in real estate syndications. Topics include: common types of syndications, real estate syndication structure, and the benefits and challenges of a real estate syndication. This article is based on a RealWealth webinar hosted by our Co-Founder and CEO Kathy Fettke and our syndication team.
Real estate syndications are a great way for investors to pool their money together to invest in larger properties that they otherwise couldn’t afford on their own. In this way, syndications provide an opportunity for a much larger return on your investment. While there are many advantages to investing in syndication deals, the most important thing to consider is the quality and experience of the person or group managing the project.
What is a Real Estate Syndication?
At its core, a real estate syndication is a group investment. Investors come together to pool their resources, so that they can enjoy the benefits of investing in larger commercial or residential real estate deals. In addition to pooling together their resources, investors are able to invest via an LLC with other partners, while simultaneously enjoying the benefits of an assigned manager who will make all of the decisions. In this vein, it is important to note that even though you are a passive investor in another person’s deal, it is still considered a “security,” which is why real estate syndications are actively regulated by the Securities & Exchange Commission.
Types of Syndications
As was previously mentioned, a real estate syndication is a partnership that can exist between a few investors or hundreds. This partnership can exist in various types of syndications, including entitlement deals, land development, diversified Single Family Fund (SFR), and any large real estate deals. With this in mind, the two most common types of syndications are entitlement deals and a diversified Single Family Fund (SFR). No matter what type of syndication deal you choose to invest in, the most important thing to consider is the quality of the person or group managing the project.
Type #1 – Entitlement Deals
An entitlement deal allows you to “tie up” a piece of land. As part of this process, you will have to work with the various regulatory bodies to approve rezoning. In other words, the regulatory bodies will have to give you the permission needed to build something on that land. Whether you are planning to use the land for commercial, residential, or mixed purpose use, you can only move forward with the project once the plans have been approved. Of course, as is the case with many real estate investments, the local and state laws will vary, which is why it is important that you a) work with a trusted industry professional, and b) select the right areas to complete an entitlement deal (such as Texas or North Dakota where it is easier to receive approval than it is in difficult states, such as California).
The next phase of an entitlement deal is to sell it to a developer for a higher price. The developer will then build based on the approved plan; however, many builders only want to buy land that is already entitled, which is why it is important that you keep the following tips in mind if you want to pursue a real estate syndication via an entitlement deal.
- Know how to work with the city councils, planners, and marketplace.
- Understand what the city wants for the future.
- Get to know the “master plan” for the city, i.e. where do they want to grow, where are the freeways being built, and what is the expected timeline.
By building valuable relationships with the people who make decisions, you are more likely to have your land entitled in an expedited fashion. It is important to point out that you could always develop the land yourself, however this option does have its own set of risks. The other risks associated with an entitlement plan include your ability to accurately calculate the property’s worth once it has been rezoned, as well as your (or the syndication manager’s) experience with the city / state regulatory bodies. The latter experience and relationships can either expedite the project or cause extensive delays.
Type #2 – Diversified Single Family Funds (SFR)
Another real estate syndication option is to pool funds together to create a SFR. This option gives you the flexibility needed to buy / hold properties. It also offers the opportunity to share rental cash flow, as well as the appreciation earned when the properties are sold. The latter factor should be carefully considered when you are planning on flipping properties at a more rapid rate. The benefit of a SFT is that the risk is diversified over numerous deals. However, the inherent challenge of the SFR, is that like an entitlement deal, you must have an accurate understanding of the market (both current and future), if you want to accurately estimate property values, rent, and the possible appreciation values. Finally, you will need to ensure that whoever is managing the SFR has a proven history of managing large portfolios, the effective communication skills needed to develop comprehensive property reports for all investors, as well as previous experience with SFRs in the states where you are purchasing, holding, renting, and selling properties.
How to Structure a Real Estate Syndication Deal?
It is important to note that the type of project (Entitlement, development, SFR fund, etc.) does effect deal structure. For example, deals are typically structured as an Equity Partnership, Private Loan, or Capital Structure. Before you embark on a real estate syndication, it is vital that you understand how it is structured, as well as the nuances of the operating agreement and the PPM. The latter two components will detail who controls what as part of the real estate syndication.
In an Equity Partnership, expenses and profits are shared between you and the developer as outlined in the offering documents. Generally speaking, Equity Partnerships tend to be a higher risk than a private loan. This heightened risk most often occurs when due diligence is lacking. However, if the risks are properly mitigated, then the Equity Partnership will typically generate a higher return for investors.
In a Private Loan, you will lend the money to a developer, who in return must pay it back. In the case of the majority of RealWealth syndications, either an Equity Partnership or Private Lending opportunity is selected and then organized into an LLC. The additional use of an LLC adds a heightened level of protection, mitigates risks, and creates the opportunity for investors to become members of the LLC, purchase a set real estate unit, and then enjoy the benefits of the LLC becoming either partners with the developer or lending the developer the funds needed to build the project.
Capital Structure (aka Capital Stack)
A Capital Stack refers to the organization of all financial capital that is contributed to a syndication. It is important to note that the capital stack defines who has the rights (and in what order) to the income and profits generated by the property throughout the hold period and upon its sale. It also defines who has rights to the actual asset in case of default. In other words, the Capital Stack clearly defines what order investors will get paid in.
Generally speaking, a Capital Stack is structured from the lowest to the highest entities. It is important to know all of the entities involved in a project because each entity will have its own Capital Stack, which means that the higher ranking entities could potentially impact how profits will flow down into your own pocket / entity. For example, should the property not generate enough property, then you want to ensure that you will still receive your money. To help you understand the various entities, you should always understand what level of investor you will be within the syndication (as well as your own entity, should multiple entities be involved).
- Secured Debt Investor. — The debt is backed by a collateral to reduce the risk often associated with lending. Should the borrower default on a payment, then the lender can seize the asset that is being used as collateral, sell it, and then use the proceeds to pay off the debt. The secured debt investor is often the least risky place in a Capital Stack. It is also great for IRA investors who want to avoid UBTI, since the income generated is considered passive. However, the downside of a secured debt investor is that the return is capped at the interest rate, which is usually a lower rate than equity investors.
- Unsecured Debt Investor. — The loan is given without any guarantee of payment, satisfaction, performance, or opportunity for return from the recipient. However, unlike a secured debt investor, no property, security, or interest can be used as collateral. The advantage of an unsecured debt investor is that the investment isn’t tied to the asset, which means that it must be paid back before equity partners can split the profits. The challenges of this type of investor is that it holds a slightly riskier place within the Capital Stack, there is no profit participation, and the return is capped at the interest rate, which is often lower than the equity investors.
- Preferred Equity Investor. — This type of investor is a member of an LLC and thus considered a shareholder in a specific property. Their stake is proportionate to the amount that they have invested. As a preferred equity investor, they are entitled to receive their share before the funds are split with the common equity investors. The biggest advantage of being a preferred equity investor is that there is a higher potential reward, however it is also riskier than debt, since it does not guarantee that the funds invested will be paid back.
- Simple Equity Investor. — This type of investor is a member of an LLC and thus considered a shareholder in a specific property. Their stake is proportionate to the amount that they have invested. These investors only receive a portion of the remaining profits of a project. While there is no preferred return (and thus a higher risk), this type of an investor is entitled to a higher percentage of profits. The main advantage of the simple equity investor is that there is a higher potential reward, however it is significantly riskier than debt or preferred equity investors.
4 Pros of Real Estate Syndications
Real Estate syndication pros and cons should always be understood before you enter into a new investment opportunity. A failure to understand the pros and cons, can result in a missed opportunity as well as the inability to actively weigh risks.
1 – Pooling Money to Invest in Larger Properties
By pooling funds, investors are able to invest in larger properties to thus expand their real estate portfolios. Through diversification, investors can enjoy the benefits associated with larger residential and commercial properties.
2 – Opportunity for Greater Investment Return
Often times real estate syndications offer the opportunity for a greater return on investment. It is important to note that the greater return on investment is dependent on a) the type of syndication, b) the project being built, and c) the type of investor status (i.e. secured debt, unsecured debt, preferred equity, or simple equity investor).
3 – Diversification of Risk / Passive Investing
There are numerous benefits associated with passive investing. In addition to enjoying passive income tax benefits, you are also able to leverage the expertise of the syndication manager, which means that you don’t have to devote as much time or effort to your real estate investment. Instead, you can simply reap the rewards, while simultaneously enjoying the benefits of risk diversification. Since other investors are involved in the real estate syndication, you will automatically spread out any of the associated financial risks, while still enjoying all of the potential benefits.
4 – Tax Deferred Status
As mentioned in one of our earlier posts about the advantages of investing via real estate LLCs, there are several tax advantages to real estate syndications. One of the biggest advantages is that you can receive tax deferred status on either one property or multiple properties in various locations.
4 Cons of Real Estate Syndications
As with any type of real estate investment, there are potential disadvantages associated with a syndication. It is important that you understand these potential disadvantages before embarking on a new investment opportunity.
1 – Experience and Knowledge is a Must
Real Estate syndications can be a bit tricky, which is why it is vital that you work with a trusted group of investors, as well as a syndication manager. To this end, make sure that you spend time reading posts (such as this one and our soon-to-be published Part 2) and researching the ins-and-outs of real estate syndications. Finally, it is vital that the person in charge of managing the project and syndication has the local knowledge needed to work with city council members, developers, and all other parties. A lack of knowledge or experience can lead to project delays, higher risks, and reduced profits.
2 – Less Control Compared to Owning Individually
One challenge of real estate syndications is that you have less control over the investment and property than when you own an investment as an individual. While there is less control, especially since you are considered a passive investor, you do have the opportunities to enjoy additional benefits, including lowered risk, that you wouldn’t necessarily experience as an individual owner.
3 – Cost of Setting Up a Fund
Depending on the type and size of the project, real estate syndications can have higher initial costs. The higher initial costs can potentially limit your ability to immediately invest in other opportunities, especially since syndications can take time to payout.
4 – Raising Enough Investor Capital
Like the preceding disadvantage, it is often hard for real estate syndications to raise the investor capital required (especially for large projects that only seek to have a limited number of investors).
How to Join a Real Estate Syndication Project
Joining a real estate syndication project is as easy as following these steps:
- Review all offering documents. As needed consult with your attorney and CPA regarding the offering documents.
- Decide how you want to hold your investment (personal name, with a spouse, in an LLC or trust, or in a self-directed IRA).
- Fill out your subscription agreement in accordance with how you want to hold the investment.
- Upload your paperwork to the secure RealWealth investor page that is associated with the syndication project.
- Be on the lookout for a confirmation email / message from someone within the RealWealth syndication department within 48 hours of submitting your documents. This confirmation will either let you know that you met the criteria needed to invest (as well as the wiring instructions), or that you are missing paperwork or that something is incomplete or incorrect.
What to Expect After Investing in Syndications
After you invest in a real estate syndication you will be able to receive quarterly updates via emails or webinars. These updates will provide you with vital information about the project’s status and performance levels. You will also receive K1 tax documents on a yearly basis, so that you can properly file your taxes based on the syndication’s performance as well as your own investment.
Whether you are just starting to explore real estate syndications or are ready to invest today, it is essential to have a solid understanding of the various types of syndications, how they are structured, and the pros and cons involved. This will allow you to ask the right questions and ensure that you are partnering with an experienced developer who will provide the greatest opportunity to profit from your investments, while minimizing risk. Stay tuned for Part 2 of our guide to syndications, where we will explore even more details regarding the opportunities that await with the right real estate syndication projects.