California has a long history of making innovative laws; it was one of the leaders in the formation of laws relating to private real estate syndicates, passing laws about it in the 1970s. In a real estate syndicate, passive investors can pool their funds in a group investment operated by an experienced real estate syndicator. Many people don’t realize that parties can form a private real estate syndicate in California without getting pre-approval from the state or federal government, but it is still a highly regulated area of the law.
The syndicator’s role is to identify suitable property, raise the money to acquire and improve it, oversee operations on behalf of investors, and eventually re-sell it for a profit.
Many California investors who do not wish to take on the responsibility of owning and operating income-producing property are interested in these syndicated investment opportunities. Investors purchase passive interests in a real estate syndicate. They then own a percentage of a company from by the syndicate to own one property or a pool of properties. This entitles investors to either quarterly income or profit-sharing payments as well as appreciation on their investment.
The syndicator will generally make capital improvements to the property (upgrading interiors of units, sprucing up exteriors and parking areas. By doing this, they can typically increase rents and occupancy levels at the property. Increased income means added value, which is usually realized on eventual sale of the property.
There are many advantages to this type of passive investing, but there are also risks, a more detailed discussion of which are provided below:
What Is Real Estate Syndication?
Real estate syndication refers to pooling resources in a company that is formed to acquire, operate, and eventually sell real estate. Real estate syndication documents include certain documents and filings required by securities regulators, plus an agreement between the syndicator and investors as to how the syndicate will be governed. The single purpose of the company is to purchase a specific property or portfolio of properties that has been identified by the syndicator.
Each of the owners of the company will be entitled to a share of profits and a share of any losses (such as depreciation that can be used to offset income) that may occur.
Passive investors versed in real estate syndication may wish to diversify their own investment portfolios by buying interests in multiple syndicates run by different syndicators.
Investing in real estate syndicates can be lucrative, with the added bonus that investors don’t have to operate a property themselves to share in profits or appreciation income and they get the benefits of owning commercial real estate with professional property management, which often has higher returns than income from single family residential properties that investors typically buy on their own. The returns in a real estate syndicate are based off the efforts of the syndicator, whose management team is actively adding value and generating profit for investors.
For their efforts (sometimes called “sweat equity”), the real estate syndicate management team (we are calling this team the “syndicator”) earns certain fees and a share of profits. The more profit generated by the property, the more there is to share between investors and the syndicator. This keeps the syndicator’s interests aligned with the interests of their passive investors. This type of investing is often called “syndicate investing” or “syndicated investing.”
How Do Real Estate Syndicates Work In California?
With this kind of investment, the syndicator forms a company (most often a limited liability company or limited partnership) to hold title a property. Investors purchase a percentage of ownership in the company, which may be called “interests” or “units”. By becoming a syndicate member, investors are given the right to profits from any property bought within that syndicate.
With real estate syndication, it is not uncommon for investors to pool their funds in properties they do not know and have never visited. What makes real estate syndicate investment so great is that passive investors are given a chance to participate in large returns on their investment, and because they may invest as little as $50,000, they have the ability to lower their risk by diversifying their investment portfolio, i.e., by not putting all of their eggs in one basket.
Benefits Of Buying Interests in Real Estate Syndicates
With real estate syndication, investors can earn a significant return on their investment, plus a return of their invested capital. Unlike traditional investing, this type of investment is less likely to become worthless as they are investing in properties that are already worth a great deal of money – and they are improving them even more.
With this type of investing, investors can save quite a bit of money as they do not need to buy the whole property to profit from it. Passive investors can take advantage of the benefits of owning commercial property without the stress or responsibility of managing a large and complex property when they don’t have the time or skills to do so.
However, these types of investments are called “investment contracts”, which fall within the definition of securities. This means that for a California real estate syndicate, where the syndicator, all investors, and 80% of the property owned by the syndicate are within California, the syndicator has to comply with a specific set of “interstate” rules (also called exemptions) designed and adopted by California securities regulators, whose goal is to protect California investors. California has several securities intrastate exemptions from securities registration whose rules syndicators can choose to follow if they decide to create a private California real estate syndicate. If a California syndicator wishes to be able to offer their syndicate interests to the public, they must register their offering (get pre-approval) from California securities regulators before they can ask investors to invest with them. Every state has its own set of rules.
However, if the syndicator is buying property outside California, and may have investors from multiple states, they typically choose to follow the federal securities exemptions from registration for creating a private real estate syndicate. Certain federal securities laws supersede the intrastate state securities laws, so a syndicator who will be crossing state lines with their syndicate (either with buying properties out of state, or having investors from multiple states) often chooses the federal rules so they only have to follow a single set of exemption rules.
Each exemption, whether intrastate or federal, has a specific set of rules syndicators must follow when making offers or sales of interests in their company to investors. Some of the rules may require that investors have a certain level of financial net worth, income, or sophistication; or they may require that the syndicator have a pre-existing relationship with the investors that pre-dates their securities offering, meaning they cannot advertise for investors for their real estate syndicate in social media, on the internet, or in any other type of ad that reaches the general public.
Certain securities exemptions may allow advertising, but they typically restrict the amount an investor can invest or have high standards for the financial qualifications of investors, such as $300k income/year for couples or $1M net worth.
1) Opportunity to Share in Profits While Passively Investing
Investing in a real estate syndication allows investors to move share in profits from cash flow (rental income), and in most cases, properties owned by syndicates are sold for a value higher than the original purchase price. This is called “equity” and whatever equity is left after paying the costs of sale and any outstanding loans, gets shared with investors. The real estate syndication structure appeals to investors who may not be able to save up enough money or are too busy with their everyday lives, but still want to take advantage of real estate investing, the opportunity to share in the ownership of a property they could not buy on their own and perhaps make more from it than they do on other non-real estate investments.
2) The Opportunity to Participate in Real Estate Ownership at a Discount
By investing in real estate syndication, investors are able to pay less to participate in ownership of real estate because the minimum investment in a real estate syndicate is usually a fraction of what an investor would pay if they bought the property on their own. With their investment (called a “capital contribution”), passive investors are buying into profits generated by the efforts of the syndicator.
3) The Opportunity to Earn Through Rising Equity
With this type of investment, if a syndicated property goes up in value and the syndicate decides to sell it, investors can earn a significant amount of money after the sale, even if they have only received small payments from them during the ownership period from cash flow. When a syndicator sells the property, they will first pay investors back their capital contributions, plus any profits earned from cash flow during ownership (called cash flow distributions), plus the investors’ share of profits from the sale (called equity distributions), which collectively, can be substantial.
Often, when the cash flow and sale profits are added together and divided over the period of ownership, investors in real estate syndicates may realize an annualized return on investment in the mid to high teens, or sometimes even higher. Profits from real estate syndicates are allocated amongst all investors in proportion to their percentage ownership in the company. This means that by buying into real estate syndication, you could make much more money faster than with other investments that are not secured by a tangible asset.
Risks Of Investment in Real Estate Syndicates
There are disadvantages to any investment, and real estate syndication is not any different. One major disadvantage to this type of investing is that you will have little control over the property that you have invested in. With this type of investment, you will be dealing with all types of individuals, and there could be serious problems with the property or how it is being managed. Still, with a syndicate, there are rarely any ways for investors to change the situation. Additionally, real estate prices rise and fall, so if a sale happens during an economic downturn, less profit may be realized.
Real estate syndicates are also usually dependent on institutional lenders, who will make a loan against a property in the range of 75% to 80% of the acquisition costs. If a loan matures and must be paid back during a time of depressed real estate prices, the syndicator may not be able to refinance it, causing the acquisition lender to initiate foreclosure proceedings. The way syndicators manage this risk is by not “over-leveraging” the properties, as happened during the Great Recession of 2010; where lenders were offering 100%+ financing, counting on continued appreciation, which didn’t occur.
Additionally, loan maturity timeframes during the Great Recession were typically much shorter than is common today. Today’s loan “balloon payments” are often 7-10 years; where in 2010, short term loans of 2-3 years were commonplace. By not overleveraging and ensuring a long enough loan term, real estate syndicates can hedge against the risks inherent in the financing practices of 2008-2010.
1) The Opportunity for Theft or Scams in a Syndicated Property
With this type of investing, investors aren’t in active control of the property or its financials, and may fail to see it if a syndicator is breaking any rules and misappropriating funds. This is one of the major disadvantages of investing in a real estate syndicate, as it can allow unscrupulous syndicators to steal from investors. However, because raising money from private investors is highly regulated by securities regulators at both the state and federal level, it is hard for syndicators to get away with these practices for long. The internet never forgets and a syndicator who steals from investors is usually exposed, caught by authorities, and then barred from ever raising money again. Moreover, the syndicator is not usually an individual, but a group of active investors, who are working together to bring the investment opportunities to investors, so no one individual has complete control of the property finances; leaving less opportunity for dishonesty.
Since there many laws governing real estate syndication companies, it’s not easy for syndicators to scam investors out of money from a property that they have invested in.
2) The Risk of Not Making Enough From Your Investment
One of the major disadvantages of real estate syndication is that if the property you are investing in does not go up in value, your money may not be returned to you. It’s rare, but it does happen. This is most likely to occur when a property has inherent structural problems that were not discovered during the acquisition due diligence process or concealed by the seller. Or when storm or environmental damage occurs, but unscrupulous insurers deny adequate coverage and have to be sued to make them perform. This happens more than you think. This can often-times be circumvented by the syndicator’s hiring of a public adjuster, whose job it is to negotiate with the insurers for a fair and adequate settlement. When investing in syndicates, it is important to consider all of the possible risks before signing on the dotted line because sometimes, no one will be able to get their money back.
Securities regulations require syndicators that selling “investment contracts” to provide all of the information investors need to make “informed consent”. The means of doing this is called a Private Placement Memorandum or PPM. The PPM typically includes several pages of risks that could be associated with the property, this type of investment, taxes and regulatory changes (such as rent control) that could affect a property’s profitability.
3) The Risk of High Syndication Fees
Also, investors should look carefully at the syndicator’s fee structures as their fees could be high and may take priority over profit distributions to investors, taking much of investors’ profit away. If the real estate syndicate you are contemplating has a very high fee structure, you should question the syndicator, and if you don’t agree with the fees they are going to charge, it might not be a good investment for you. Be prepared to walk away if something doesn’t feel right.
4) The Risk of Suffering a Serious Loss
With this type of investment, investors take the risk that they may end up losing all or part of their money. Passive investors are always taking the risk that their investment could go unattended; perhaps because something happens to the syndicator (illness or death), or they are spread too thin over too many deals, leaving your investment to languish.
5) The Best Way to Minimize Investor Risk
A syndicator must follow and document compliance with these very specific securities exemption rules. Anyone who doesn’t do so is violating securities laws, which could subject them to civil litigation from regulators or investors, fines and penalties, and if they are willfully doing something wrong (like stealing money or misleading investors), they can even go to jail and be barred from ever raising money again. It behooves passive investors who invest in real estate syndicates to learn the rules of the exemption for the offering that a real estate syndicator is promoting so they can spot those who don’t know or follow the rules – as securities violations will ultimately put every investors’ investment at risk.
However, the best way to minimize the risk of investing in a real estate syndicate is to conduct due diligence on the syndicator (and all of its members), both on the internet, and by asking questions.
- What securities exemption are they following? What are its rules?
- Ask for their track record; how many properties like this have they syndicated with investors?
- Were the results what they promised investors?
- How many have gone full cycle (acquisition to sale)?
- How many syndicates are they operating now?
- How much time will they have to devote to this property?
- What is their fee structure?
- Is there a way for investors to “claw back” syndicate management fees if they don’t get their promised returns?
- Check with California securities regulators to see if the syndicator has any prior complaints against them.
- And ask for referrals to prior investors.
Ask who their securities attorneys are, and make sure they are working with a reputable firm (like us!).
