Real estate has enough ways to successfully invest that it can make your head spin but just about everybody can find an option that suits their personality, risk profile and goals. In recent years one method has grown incredibly popular, the multifamily syndication. This type of investment is perfect for investors who do not want to be concerned with the three "T's," the Tenants, Trash, and Toilets or for those who do not want to be a landlord but who are confident in real estate as a powerful investment vehicle. Syndications are also great for people who already have lucrative careers and want to invest some of their funds in real estate and those who desire a passive investment.
This is the first part of a two-part series where we take a dive into real estate syndications at an elementary level. We will barely be scratching the surface but what we will cover will help you feel comfortable as you embark on the road to investing in real estate syndications. In this part we will cover what a syndication is and what you can expect during the life cycle of the investment from the point where the syndicator first notifies you of an offering to the sale of the asset. In the second part we will cover the most common ways the two groups receive compensation throughout the investment.
What is a real estate syndication?
Simply put a syndication is a group of persons or concerns who combine to carry out a particular transaction or project. Bruce Peterson, in his book, Syndicating is a B*tch, more clearly defines a syndication for real estate as a group of people coming together to put money into an investment, which will be managed by one person or one small group for the benefit of the larger group.
Even though these are investments in real estate they are a security and actively regulated by the Securities and Exchange Commission (SEC). Under the Securities Act of 1933, any offer to sell securities must be either registered with the SEC or meet certain requirements for exemption from registration. Registering a security is commonly referred to as "going public" and includes considerable upfront costs along with highly burdensome reporting requirements that are unsuited to most real estate deals. Because of this, most syndication operators choose to pursue one of two types of exemptions under rules 506(b), or 506(c) of Regulation D (Reg D).
Who are the participants in a syndication?
There are two main groups within a real estate syndication. There is the individual or group who is referred to as the syndicator or sponsor. This is the general partnership (GP) and they are responsible for finding the deal, performing the due diligence on the property, sourcing sufficient and acceptable financing, raising money from qualified investors and managing the property after close of the purchase. The other group is the limited partnership (LP) who is responsible for vetting the sponsor and providing capital for the equity portion of the financing (down payment and operating reserves).
Who is a qualified investor?
Only qualified investors are permitted to invest in real estate syndications as limited partners but who is a qualified investor? To be a qualified to investor you must either be and accredited investor or a sophisticated investor.
The historical definition of an accredited investor is someone who has a net worth of at least $1,000,000 not including their primary residence or has an income of at least $200,000 each year for the last two years (or $300,000 if married and filing jointly) and have the expectation to make the same amount this year. In August 2020, the SEC amended the definition to include individuals with certain professional certifications such as their Series 7, 65, or 82 license, and individuals who are knowledgeable employees of a fund. The press release can be found here.
A sophisticated investor is a person who does not meet the requirements to qualify as an accredited investor but can attest that they have sufficient knowledge to make an informed decision on the merits of the investment and understands the potential risk as well as the upside.
If an individual does not meet at least one of these qualifications, then currently they are unable to invest in real estate syndications.
Two types of offerings, what is the difference?
There are two main types of real estate syndications that we tend to focus on, one is structured under Rule 506(b) and the other is structured under Rule 506(c). While they both serve the same end purpose, they have quite different guidelines that a sponsor must follow. The two main differences are the investor requirements and the advertisement guidelines.
In a 506(b) offering the sponsor is not allowed to generally solicit from the public meaning they cannot talk about nor can they advertise the deal outside of their network of investors who they have a substantive relationship with. In exchange for not being allowed to advertise, the SEC allows the sponsor to include up to 35 non-accredited, sophisticated investors in the LP. The substantive relationship definition has been left intentionally vague by the SEC but suggests that the relationship exists when the sponsor knows enough about a potential investor to know their financial situation and has a system to show that their relationship was in place prior to making them an offer to invest. Another suggestion is to observe a 30-day cooling off period between the first meeting the sponsor presenting the investor with an offering.
A 506(c) offering does not have the limitations regarding solicitation, preexisting relationship, or cooling off period. In exchange for these benefits the rule dictates that only certified accredited investors are permitted. In these offerings the sponsor is required to take reasonable steps to verify that an investor is accredited. Third party verification is often recommended as well as a common practice.
Why invest in real estate syndications?
1. Secured by hard asset. Unlike stocks and bonds, a real estate syndication is secured by a hard asset, the property being purchased. As a limited partner you can see and touch the asset you invest in, it is not a company in the cloud.
2. Greater return through cash flow and appreciation. Common IRR's on multifamily syndications is in the 15%-20% range and can sometimes be even higher. This return is superior to typical mutual fund returns.
3. Ability to participate in larger deals, and unlike REIT, you can choose the individual properties you invest in. Both syndications and REITs allow you to participate in larger properties without having to manage them yourself. When you invest in a REIT you are investing in hard assets, but you do not have any say in what properties are included. The fund managers are who make the decision based on the bylaws written into the security. With syndication you can choose every asset you invest in. If, for example, you do not want to invest in a certain city or neighborhood you can choose to not invest there in a syndication but not in a REIT.
4. Tax Advantages. Most of the tax advantages, including depreciation, flow down to the limited partnership. This is not the case in a REIT where depreciation is not passed to the investors. In a syndication you receive your schedule K-1 toward the beginning of the year which will outline your share of the income and losses including depreciation.
What is the lifecycle of a syndication?
1. Executive summary. Most likely the first time an investor hears about a specific offering is via an email from the sponsor containing the executive summary (ES). The ES is the business plan for the investment, provides an overview of the strategy, summarizes the implementation plan, and provides background on the key partners.
2. Webinar. After sending out the ES the sponsor will invite potential investors to a webinar where they will present the offering and open the floor for a question and answer session. This is a great time to ask any pertinent questions about the deal or the sponsor.
3. Soft commit. After the webinar the sponsor will be looking for soft commitments from investors, so they have a rough idea of the interest in the offering. Deals tend to fill up quickly so the sponsor will likely specify that they will accept investors on a first come first serve basis.
4. Operating agreement (OA) and/or Private Placement Memorandum (PPM). After receiving the soft commit, the sponsor will send out the OA and/or the PPM for review at which time
5. Wire funds. After signing the OA/PPM you will wire the funds or send a check for your commitment to the account specified.
6. Confirmation of receipt of funds. It is important to receive a confirmation that the funds have been received.
7. Regular updates from the sponsor. Over the course of projects life cycle, you can expect periodic updates from the sponsor which can include quarterly performance reviews and distributions as well as annual tax documents such as the Schedule K-1. Another important communication from the sponsor is in the event of a potential refinance or sale of the property.
8. Receive share of property sale. When the business plan of the syndication has been fulfilled and the property is sold the sponsor will distribute the share of the profits as outlined in the OA/PPM
But, how do you make money as a limited partner?
Stay tuned, next we continue this topic and reveal the most common ways the LP makes their money during a syndication.
If you have any questions or if there are any topics you would like to see covered please reach out to me at Mack@InfiniteFocusCapital.com
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