Real estate syndication is a term that’s gaining traction in today’s property market. But what exactly does it mean? And how can it benefit both seasoned and novice investors? In this comprehensive guide, we delve into the ins and outs of real estate syndication, detailing its benefits, risks, and the process involved.
What is Real Estate Syndication?
A real estate syndication is a means for a group of passive investors, organized by a “syndicator” or “sponsor,” to pool money with which to acquire, operate and dispose of real estate for profit.
Real estate syndication that involves raising capital from private investors is regulated by the federal Securities and Exchange Commission (SEC) or state securities agencies (sometimes both), as it usually involves the sale of “securities” in the form of an “investment contract.” A securities offering must be registered (pre-approved by the regulatory agencies) unless exempt from registration, which generally requires following a strict set of rules and filing of exemption notices with applicable securities agencies.
The syndicator will find a suitable property (or property type), form a real estate investment company (usually a limited liability company or limited partnership) to acquire it and then coordinate a group of investors who will contribute cash to the company for the purchase price (less any bank loans), closing costs, operating capital and reserves, and certain syndication management fees. A company formed to acquire real estate and raise capital from private investors is called a “syndicate” or “syndication”.
The syndicator will conduct due diligence on the property prior to acquisition and will manage the company on behalf of the investors during ownership of the property until such time as it is eventually re-sold. In exchange for their cash contributions, investors will receive a membership or ownership interest in the syndication, which will entitle them to a share of profits derived from rental income and/resale, along with a return of their investment on sale or refinance of the property.
The 12 Ways a Syndicator Can Be Compensated
Profit Distributions
Syndicators typically earn between 20% and 50% of the distributable cash generated from operations, refinance or sale of a property, which may be paid as a direct split between the members and the syndicator (i.e., 70/30) or as a preferred return to the investor class, followed by a split.
Phases of operations that can generate distributable cash include:
- Excess cash flow from rental income
- Excess cash received from a refinance loan – this is usually used to repay all or a portion of the investors’ original capital contributions
- Equity realized on sale of the property – equity is typically generated from improvements the syndicator has made during ownership of a property that allows rents to be increased and expenses to be decreased (such as implementing utility bill-back programs).
Note: It could be a long time before a property generates distributable cash that can be shared between the syndicator and investors. For commercial development projects, it could take 3 years or more; for value-add syndications that purchase and improve existing properties, it could easily be 1-2 years before distributable cash is generated. Where investors are offered a “preferred return”, it could take even longer before a property generates sufficient cash flow to cover the investor’s preferred return and still have something left to pay the syndicator.
Syndicator Fees
So how does a syndicator survive until distributable cash is generated? Syndication management fees. Syndicator or syndication management fees are typically treated as an expense of the syndicate (prior to determining distributable cash). They may be collected by the syndicator on a monthly, quarterly or annual basis. Syndication fees aren’t meant to be a syndicator’s primary source of income, but they are meant to keep the syndicate management team from starving or turning their attention to other investments or employment so they can feed their families.
Syndicate investors should beware of any syndicate whose structure doesn’t allow the syndicator to earn fees or a share of profits until the property is sold – it misaligns the interests of the syndicator and investors. The investors may be enjoying cash flow while the syndicator is starving and needs to sell the property so they can get paid, or move on to other investments that do pay. This model isn’t sustainable long-term for either the syndicator or investors.
The type of fees a syndicator may earn are:
- Acquisition fee (1% to 3% of the purchase price)
- Asset management fee (1% to 2% of gross collected revenue)
- Refinance fee (1% to 2% of the refinance loan amount)
- Disposition fee (1% to 3% of the sale price)
- Loan guarantor fee (1% to 2% of the loan amount or a flat fee) this fee is usually paid to members of the syndication management team whose primary role is to provide their experience and financial net worth to help the syndicate qualify for loans on specific properties
- Interest on loans made by the syndicator to cover capital raise shortfalls or expenses that the syndicate can’t pay from cash flow (8% to 12% of the loan amount)
Note that syndicator fees will always be taxed at ordinary income rates and will be considered “active” earnings for tax purposes, subject to self-employment tax.
Real Estate Brokerage Fees
A syndicator who is a licensed real estate broker or agent in the state where the property is located may also earn commissions or fees for providing licensed brokerage activities to the syndication, including:
- Commissions on purchase of a property
- Resale commissions
- Property management fees
Expense Reimbursement
In addition to the fees and distributions a syndicator may earn, the syndicator can get reimbursed for pre-closing expenses that it has to front prior to closing on a property. Pre-closing expenses include such things as property deposits, fees paid to lenders, private equity partners or due diligence consultants, legal expenses incurred during organization of the company and the offering, real estate attorney fees for drafting a purchase agreement and negotiating with a seller, and travel to the property.
Pre-closing expenses must generally be borne by the syndicator – who shouldn’t use investor funds until closing on a property. If a property doesn’t close, the investor’s funds should be promptly refunded without deduction. Pre-closing expenses in a real estate syndicate are the syndicator’s risk to bear.
Benefits of Real Estate Syndication
Investing in a real estate syndication comes with several advantages. First, it offers financial leverage. By pooling resources, investors can access larger, more profitable deals than they could alone. Second, it provides portfolio diversification. Investors can spread their risk across multiple properties instead of putting all their eggs in one basket. Last, investors can benefit from the expertise and experience of the syndicator, who handles all aspects of the project management, and has the requisite training or experience to be able to manage syndicated investment properties.
How Does Real Estate Syndication Work?
The process of real estate syndication involves several steps.
- Deal Identification: The syndicator finds a potentially profitable real estate opportunity.
- Due Diligence: The syndicator analyses the deal to ensure it is viable and profitable.
- Deal Structure: The syndicator decides how the deal will be structured, including the profit split between the syndicator and passive investors, and the projected investment terms.
- Capital Raising: The syndicator presents the deal to potential investors who, if interested, commit their capital.
- Property Management: Once the deal is funded, the syndicator hires and oversees local property managers who manage the day to day operations of the property, and ensures its business plan is implemented in such a manner as to generate profits for investors.
Types of Real Estate Syndication
Syndication is simply pooling resources (time, effort, and money) for a common purpose. It doesn’t matter if the money will be used to buy a single property that a syndicator has under contract, multiple properties yet-to-be-identified, or to make loans to real estate investors – each model basically requires the same corporate structure (with some variation), the same legal compliance with securities laws, and the same players – a management team (the syndicator) and passive investors.
Below are four main real estate syndication models:
- Specified Offerings: Passive investors own a share of the company that acquires one or more previously identified properties. For commercial properties, the syndicator will get a bank loan for a portion of the purchase price and will raise the rest from private investors. Investors will earn a share of profits proportionate to their ownership interests in the company.
This is the easiest way to raise money and most syndicators can manage a handful of investors using an investor management platform on their own. Every new syndicator should start here.
- Real Estate Funds: Instead of identifying a specific property to acquire, a syndicator will prepare a business plan (also called an “investment summary”) explaining its investing criteria and desired asset classes. Because no specific properties have been identified prior to raising money, this is called a “blind pool fund.” Passive investors invest in the fund (usually formed as a limited liability company or limited partnership). The syndicator or “fund manager” then looks for properties meeting its investment criteria for the fund to acquire, with the idea being that the fund expects to acquire multiple properties. After-expense cash flow and equity realized from the eventual sale of fund properties is split between fund investors and the fund manager.
The syndicator (or fund management team) must be able to demonstrate that they have sufficient experience profitably owning and operating the same asset class or they will likely be unsuccessful raising any money. Additionally, fund administration is challenging. Professional help may be needed to properly administer a fund – this may drive up the cost of having a fund and reduce returns available for distribution to investors and the syndicator.
- Mortgage Funds: Alternatively, a blind pool fund may be created to pool money from private investors. The pooled funds are selectively loaned to active real estate investors. The loans made by the mortgage fund are recorded against specific properties as real estate mortgages or trust deeds.
Mortgage pools are frequently used to fund borrowers who do single family fix and flips and don’t have a ready source of institutional financing. The borrowers pay interest on the loans; a portion of which is passed on to investors in the mortgage fund; with the rest retained by the fund manager. Mortgage pools are most likely to succeed if they are created by fund managers with prior experience in the mortgage industry evaluating deals and borrower qualifications, and servicing loans (collecting payments and foreclosing on non-performing loans).
- Funds of Funds. This really isn’t a “real estate syndication” model, but we get asked about it all the time. This is really a blind pool fund that is formed to invest in others’ deals. This sounds like a great idea until you learn about the regulatory requirements. A syndicator that investors directly in real estate or real estate mortgages only has one set of rules to follow – The Securities Act of 1933. If you are instead buying “securities” in others’ real estate or mortgage offerings that you don’t manage, you are now considered a “private fund” that has to comply with not one, but three sets of rules – The Securities Act of 1933, the Investment Company Act of 1940 and the Investment Adviser’s Act of 1940. Compliance can be complex and time-consuming. The rules regarding private funds are ever-increasing and making it more and more difficult to use this model. In most cases, this isn’t the right model – especially not for new syndicators. To read more about this, get a copy of my book, How to Raise Capital for Real Estate Legally, available on Amazon at the following link: [INSERT LINK]
Risks Involved in Real Estate Syndication
While real estate syndication has its advantages, it also comes with risks. These include market risks, management risks, liquidity risks, and tax risks. Market risks are factors like economic downturns, property market crashes, or rising interest rates. Management risks arise from poor management by the syndicator. Liquidity risks refer to the difficulty investors may face when trying to withdraw their investment.
Tax risks: It’s critically important to have experienced corporate securities counsel properly structure a syndicate so that:
- The syndicator’s earnings from fees are separated from its share of profits or all could be taxed at the highest possible rate; and
- Profit and loss allocations to the syndicator and investors provide the greatest allowable tax benefits – and that such benefits are allocated to those who can actually benefit from them.
An improperly structured syndicate (or using a CPA who doesn’t understand group investments) can result in disastrous tax consequences for the syndicator and investors. We’ve seen it happen and sometimes it isn’t fixable.
How to Invest in Real Estate Syndications
Investing in real estate syndications involves careful consideration. It’s crucial to understand the terms of the offering, the projected returns, and the track record of the syndicator. Always conduct your due diligence about the syndicator and the proposed investment strategy before investing. Consider seeking advice from a financial advisor, CPA to ensure that the investment (and the associated risks) are suitable for your investment portfolio. Consider hiring an attorney versed in real estate syndicates or funds to review the offering materials to ensure that the offering is compliant with securities laws and that you understand the investment strategy being offered.
How is Cash Distributed in a Syndicate?
After payment of expenses (including any loan payments) and setting aside reserves, any remaining cash left over from rental income, refinance or sale of property is considered “distributable cash.” During ownership of real property, distributable cash is generally evaluated and distributed on a quarterly basis.
The proceeds from any refinance or sale of a property may first be used to return all or part of the investors’ cash investment (i.e., “capital contributions”), and any remaining distributable cash will be distributed to the members of the company and the syndicator according to a “waterfall” that is usually described in the company’s operating agreement or limited partnership agreement. The syndicator will distribute cash to investors pro rata, in accordance with their respective percentage interests in the company, or as otherwise described in the waterfall. An investor’s percentage interest is typically calculated by dividing the amount of an individual investor’s capital contributions by the total capital contributions of all of the investors.
What is the Syndicator’s Risk?
Depending on the purchase price of a property, a commercial real estate syndicator may incur anywhere from $50,000 to several hundred thousand dollars in pre-closing expenses to get a commercial property to the closing table. If a syndicator doesn’t have this much money on their own, they can borrow the money from family and friends, use personal credit, or invite management-level partners to its syndicate management team who can provide these “at-risk” funds, with the understanding that if the deal doesn’t close, the pre-closing expenses will be lost. If anyone asks, this is the syndicator’s “skin in the game.”
It’s critically important to have experienced corporate securities counsel properly set up a syndicate so that the allocations of profit and losses made to the syndicator and investors provide the greatest allowable tax benefits – and that such benefits are allocated to those who can actually benefit from them (for example, self-directed IRA investors can’t use depreciation allowances). An improper structure (or using a CPA who doesn’t understand group investments) could result in disastrous tax consequences for the syndicator and investors. We’ve seen it happen and sometimes it isn’t fixable.
What are the Rewards of Syndication for Passive Investors?
Distributions and Investor Classes
Equity investors and the syndicator will earn distributions periodically during operations, or on refinance or disposition of the property. A typical syndication may offer equity investors a preferred return (typically 6% to 10%) calculated against the amount of their initial investment, with any remaining distributable cash split between the investors and syndicator (e.g., usually somewhere between 80/20 or 50/50). An alternative structure is a straight split of distributable cash (e.g., 50/50 or 75/25) between the investors and the syndicator.
It is possible to create a syndicate or fund where there are multiple classes of investors, each of which have different rights. For instance, a syndicator could create a preferred class that earns a fixed, simple, preferred return on the amount of their investment, before the syndicator and/or other equity investors split the rest.
Other reasons to create separate classes is to reward those who invest more with a higher preferred return or a different split than other classes, or to incentivize early investors in a fund by offering bonus returns.
Fees that Investors Can Share
In addition to distributions, an investor who agrees to co-guarantee a loan on behalf of the syndication may earn a loan guarantor fee, which could be 1% to 2% of the loan amount or a flat fee.
Rules And Regulations For Syndicates Under The SEC
The United States Securities and Exchange Commission (“SEC”) requires syndicators to comply with laws concerning the sale of securities. Syndications that offer interests in a company in exchange for an investment of capital and a promise to provide a return on investment are selling securities in the form of “investment contracts”. Syndications must remain compliant by following the regulations controlling “private placement offerings” found in SEC Regulation D.
Rules And Regulations
Strict rules (called “securities exemptions”) offered under Regulation D control a syndicator’s manner of raising capital from passive investors. Additional SEC rules for real estate syndicators include the following:
- They must fully comply with SEC Regulation D by choosing to follow one of its exemptions. The most common exemptions are Rule 506(b) and Rule 506(c), each of which have a very specific set of rules.
- Rule 506(b) allows an unlimited number of accredited investors and up to 35 non-accredited, but sophisticated investors – but NO advertising.
- Offerings that include non-accredited investors must provide disclosures in the form of a private placement memorandum, whose content in part, is prescribed by the SEC.
- Rule 506(c) allows an unlimited number of verified accredited investors, but a syndicator can freely advertise
- Regulation D forbids transaction-based compensation (commissions for raising capital) to be paid to anyone other than SEC-registered broker-dealers
- Industry standard is to provide an offering package that includes the private placement memorandum with an investment summary describing the investment opportunity, a subscription agreement with an investor questionnaire that the investor completes to demonstrate their sophistication and ability to withstand the loss if one of the disclosed risks occurs and causes a loss of their investment, and a copy of the operating agreement that describes how the syndicate or fund will be operated.
Final Thoughts
Real estate syndication offers a unique opportunity for investors to access larger deals and diversify their portfolio. However, like any investment, it comes with its own set of risks.
Therefore, proper research and understanding of the syndication process, the syndicator’s experience, and the investment opportunity being offered are essential before diving in. At Syndication Attorneys, PLLC, we will be happy to discuss your syndication goals with you. You can schedule a free, 30-minute consultation by clicking this link.
FAQs
How Do I Split Money With Investors?
There is no “right” answer on how to split money with investors. The answer depends on the deal. In your early deals, your friends and family who believe in you and what you’re doing are your most likely investors. At Syndication Attorneys, PLLC we help plenty of new syndicators do their first deal without an experienced syndicator on their team. If you are trying to crowdfund (advertise) your offering, you will need an experienced syndicator with a significant track record on your team. Read More
What Might Happen if I Lie About My Financial Qualifications to Get Into a Deal?
Some securities exemptions like Regulation D, Rule 506(b) (and certain state securities exemptions) allow limited investments from non-accredited but financially sophisticated investors with a pre-existing relationship with the syndicator. Some syndicators may still restrict offerings to accredited passive investors to minimize liability. Read More
By understanding the intricacies of real estate syndication, you’re one step closer to making informed and profitable investment decisions. Remember, knowledge is power, especially in the world of real estate investing!
