As a landlord, if you don’t get up at 2 a.m. to fix a plumbing emergency, you don’t want to bother with this passive real estate investment strategy. The art of teaming up to buy real estate isn’t new, but surprisingly, not many people know what it is and how it works. Hence, in this article, I will focus on a specific type of passive real estate investment vehicle called the Real estate syndication.
A real estate syndication is a group of two or more investors or investment companies who come together for a common goal; to raise capital for the purchase of a property or the construction of a new property. The benefit of pooling your money with other investors is that you can invest in a much larger, more lucrative business that could otherwise be too expensive for a single investor. In addition, unlike a REIT (Real Estate Investment Trust), the asset is already identified during a syndication and the investors collect money for this special opportunity.
Brief History of Real Estate Syndication
Historically, until the introduction of the Securities Act of 1933, a real estate entrepreneur or sponsor could publicly advertise and solicit private funding from anywhere. Thereafter, all new private offers must be registered with the Securities Exchange Commission (SEC). . The SEC put this rule in place to protect investors from fraud, but it also appeared to block the syndication process, making it far less efficient.
However, the SEC offered a few exemptions that allowed sponsors to skip registration under certain conditions:
- Collect money through private advertising and avoid registration or
- Register with the SEC, wait for approval, and then request public funding.
The first option almost always seemed more efficient to sponsors, and private syndication continued despite the Securities Act regulating public advertising.
The general tendering rules were further relaxed by the JOBS Act of 2012, which allowed investors to participate as long as certain criteria were met and every investor was accredited. An accredited investor is someone who:
- an annual income of $ 200,000 for the past two years (or $ 300,000 if you are married)
- a net worth of at least $ 1 million, excluding private residence (individually or jointly)
The syndication of real estate is a legal transaction between two parties – the sponsor / syndicator / general partner (GP) and the investors / limited partners (LP). Legally, a syndicate can be structured as a Limited Partnership (LP) or Limited Liability Company (LLC). A sponsor’s role is to explore a property, seek funding, and manage day-to-day operations, while investors do most of the financial support. A sponsor should have adequate real estate investment experience and the ability to draw up the potential investment opportunity and perform due diligence. In addition, a sponsor typically invests between 5 and 20% of the total equity required. Needless to say, the more skin a sponsor has on a deal, the better it is for investors.
Hire a real estate attorney to draft a contract that clearly sets out distributions, voting rights, sponsor’s right to property management fees, communication requirements, etc. to protect everyone involved. Consider scheduling quarterly meetings to discuss property progress and next steps.
How is syndication different from a trust or a fund?
On the surface, real estate syndication may look a lot like a real estate trust, but there are some differences between the two.
Real Estate Investment Trust (REIT)
- It is modeled on an investment fund that owns, operates or finances income-generating real estate
- It provides a steady stream of income by paying dividends to its investors, but offers little capital appreciation
- REITs are publicly traded like stocks, which makes them highly liquid assets
Real estate syndication
- This strategy invests in a physical property value
- Investors are bound for the agreed term and the sponsor decides when the property will be sold or refinanced
- It provides access to large, lucrative investment opportunities with property management services
- Also offers several tax advantages like 1031 exchange, Continuous deductions and asset depreciation
How does a syndication make money?
A sponsor and its limited partners make their money from two main sources – appreciation and rental income. The rental income is distributed to the investors monthly or quarterly by the sponsor. Over time, as the property continues to increase in value, investors typically generate higher rental income and eventually make high profits on sales. The duration of a syndication varies depending on the sponsor and the type of property. While some syndications can be completed within a year, others can take 7-10 years. As a rule, however, a Syndication lasts 3 to 7 years. And each party involved receives a profit sharing according to the agreed terms.
A sponsor often takes an upfront profit-sharing fee for the sourcing and acquisition of a deal called an acquisition fee, and it is typically around 1% of the property’s value. In addition to profit sharing, most syndications offer what is known as the “preferred rate of return”. This means that an investor is in a preferred position for distributions until they reach the preferred return hurdle. That means the property is not producing enough cash flow to keep that promise. Preferred returns are usually between 5 and 10% annually of the initial investment.
Syndication allows you to diversify your portfolio as you only invest a small amount at a time and may still have the opportunity to explore other types of investment opportunities without being tied to a single property. In addition, syndication as an investor is one of the most passive investment ideas that requires little upfront effort to achieve a killer return on investment.
However, it helps to understand some of the syndication drawbacks, such as lack of liquidity and control over the property when locked for a specific term. Your sponsor also decides whether to sell or refinance. In addition, unlike property, you do not have the ability to build long-term equity in an asset.
After all, like any other investment vehicle, investing in real estate syndications has advantages and disadvantages. As an investor, it is imperative that you understand the basics in order to conduct preliminary due diligence on your part and, more importantly, agree on whether this strategy will help you achieve your financial goals. Remember, you don’t have to choose one or the other; You can still invest in a syndication while you are already invested in a property or trust. Since investing in passive real estate with the necessary due diligence is always a gain for me! Good luck!