Is Real Estate Syndication Investment Right For You?
Is real estate syndication investment right for you? It depends! But do you have to invest in real estate to become financially independent? Most likely not! So why bother? Because real estate investment provides diversification and hedge against inflation. Besides interests and dividends from stocks and bonds, real estate generates yet another passive income stream.
This article is an overview of real estate syndication, a type of passive real estate investment. You can either invest actively or passively in real estate depending on your comfort level, experience and availability.
Let’s dig in.
Active vs. Passive
Active real estate is when you directly own a piece of property. Beside the pride of owning a property, there are other advantages of active real estate investment, namely, decision making power (you are in control), tax benefits (depreciation and deduction of expenses), equity capture and property appreciation. However, active real estate investment is not without drawbacks such as illiquidity of capital, time commitment, repairs and maintenance costs, and personal liability.
With Passive Real Estate investment, you give someone else control of managing assets. You also don’t get to keep all the profit as management companies will get the piece of profit in addition to administration fees. At the same time, passive real estate investing is less time consuming and comparatively easier to invest in. In addition, your personal liability is limited, and does not go beyond your investment.
So if you do not want the hassle of active real estate investing and are okay with handing over the control to someone else, consider passive real estate investment such as Real Estate Syndication, Real Estate Investment Trusts (REITS), or Real Estate Funds. This article provides an overview of real estate syndication.
Real Estate Syndication
Real estate syndication is basically a bunch of investors pulling money together to buy a property since it may not be possible to purchase by an individual investor. The examples of real estate syndication investment include multi-family (apartment complexes), warehouses, strip malls, offices. etc.
There are two categories of partners in real estate syndication.
- General Partner (GP) or Sponsor: Responsible for running the syndication (managing property, documents, tax filing)
- Limited Partner (LP): Individual investors
The GP charges fees to manage the syndication, typically 1% to 2% based on the gross revenue collected from the property. In addition, there are other fees such as acquisition fees, property management fees, financing fees, disposition fees, etc.
Unlike publicly traded REITs, the real estate syndication is a private equity investment. Therefore, the barrier to entry is high for real estate syndication. In fact, you have to be an accredited investor to participate in real estate syndication and the minimum investment amount is generally $50,000.
This is directly from U.S. Security and Exchange Commission (SEC) bulletin:
An accredited investor, includes anyone who:
- Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
- Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence)
Most real estate syndications only invite accredited investors so they do not have to register with the SEC which could be a resource intensive process. In doing so, real estate syndications assume that the individual investor has sufficient experience in financial matters to evaluate the risks associated with the investments.
The syndication management company will ask individual investors to provide documents such as W-2 forms and/or tax forms or a certificated letter from the CPA to validate accredited status.
Before going into the distribution structure which determines profit split between GP and LP, let’s define certain terms.
Preferred Return: Generally non-compounding return of 7% to 8% per year on unreturned capital amount; it is paid either monthly or quarterly (more common).
IRR (Internal Rate of Return): This is an expected compound annual rate of return which includes cash flow from the investment.
Equity Multiple: This is the total distribution received from the investment divided by the invested capital. For instance equality multiple of 1.8 means the investment achieved a 80% gross profit.
Distribution Structure of Real Estate Syndication
Like any other equity investments, real estate investment also involves risk. So the most important question is how are you going to be compensated for the risk? To answer that question, we have to understand the distribution structure or “waterfall” structure of the “deal”. The waterfall structure defines the priority of cash distribution to GP and LP from operations and from sales.
There could be so many variations of waterfall structures. Let’s choose one of the simplest waterfall structures as an example.
- 7% preferred return to LP on capital (non-compounding)
- Return of capital
- a 70% LP / 30% GP split thereafter
Let’s assume that 100% of $1 million equity is raised from LPs and GP has no equity stack. Based on 7% preferred return, LPs expect to receive $70,000 (7% of $1 million capital invested) cash flow distribution per year.
In most real estate investments, the preferred return is not consistently fixed every year. Because preferred return is paid from the net distributed cash from the operations which varies. In fact in most cases, cash flow distribution is lower than preferred return in the initial years. Should the cash flow distribution fall short of the preferred return, the shortfall accrued to the following years. Then, the accrued unpaid preferred return would be returned to LPs at the time of sale.
The Cash Flow
Following is the hypothetical net cash flow distribution from the property:
|Year||Cash Flow Distribution||Accrued Preferred Return||Total Accrued (cumulative)|
*Actual Cash Flow = $40,000
Expected Preferred Return = $70,000 (7% of $1 million)
Accrued to the following year = $70,000 – $40,000 = $30,000
So in this example, there is a total of $80,000 in an unpaid preferred return.
In year 6, the property is sold and equity proceeds from sales after all expenses is $2 million.
The cash flow to LP / GP would be as follows
|Year||Cash Flow Distribution||LPs Cash Flow||GP Cash Flow|
$80,000 (accrued preferred ) + $1 MM return of capital + 70% of remaining cash flow ($2 MM – $ 1MM – $80,000 accrued preferred)
30% of remaining cash flow ($2 MM – $ 1MM – $80,000 accrued preferred)
LPs’ Internal Rate of Return (IRR) for this investment is 13.3% (calculated using excel IRR function).
Equity multiple = total cash flow / equity invested
= (40,000+50,000+60,000+60,000+60,000+1,724,000) / 1,000,000 = 1.994
Should you have invested $50,000 in this investment, your investment would have almost doubled to $99,700 ($50,000 x 1.994) over six years!!!
What if the property is sold in year 10 instead of year 6? Assuming cash flow from year 5 to year 9 stays the same, the cash flow distribution would be as follows:
|Year||Cash Flow Distribution||Accrued Preferred Return (Cumulative)||LPs Cash Flow|
$120,000 (accrued preferred) + $1 MM return of capital + 70% of remaining cash flow ($2 MM – $ 1MM – $120,000 accrued preferred)
LPs’ Internal Rate of Return (IRR) for this investment is 9.8% and equity multiple of 2.246. So in this case, IRR went down (due to a longer holding period) while equity multiple went up (due to additional cash flow).
Real Estate Syndication Risk Factors
The investment in real estate syndication is not without risk. As a matter of fact, you could lose your entire investment.
Leverage is one of the most common financial risks. Should the real estate market fall like 2008-2010 or the property experiences higher than expected vacancies or unexpected expenses, the net operating income may not be enough to cover debt payment. There is a term in real estate called Debt-Service-Coverage-Ratio (DSCR) which is net operating income (NOI) divided by total debt service. If NOI is not enough to cover the debt payment, DSCR would be less than 1.0. As an investor, you would like to see higher than 1.0 DSCR, typically in the range of 1.3 to 1.5. For instance, DSCR of 1.3 means that the property generates 30% additional income over its debt payment.
The other risk factors are volatility in the real estate market, high vacancy rate, competition in the area, higher interest rates, and lack of general partners experience.
Is the real estate investment right for you? It depends! Unlike stocks, bonds and publicly traded REITS, real estate syndication investments are illiquid and also require higher capital investment. In addition, most investments are highly leveraged and there is a risk of total loss of invested capital.
On the other hand, there are advantages to investing in real estate syndication such as diversification, ability to invest in larger projects, and ability to generate another passive income stream.
If the latter appeals to you, learn more about real estate syndication and consider making it a part of your overall portfolio.
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