Perhaps you are a real estate investor already. You’ve done some single-family deals and have realized that the economy of scale is better in multifamily. It’s time to make your move, but you are finding that multifamily properties are usually more expensive than single family ones. Suddenly you are priced out of the market.
It’s a rare investor who can buy a large apartment building by themself. If they could do so, they wouldn’t need to consider partnering. But, for most of us, the way to get the funds for those bigger deals is to find another person with the same mindset and goals and pool your money together to make the purchase. Each of you risks some money, each makes decisions about the property, each does some work, and each gets a share of the profits. This is called a joint venture and usually works like that but can be set up in many different ways. In the end, both will need to guarantee a loan and both usually risk their money and take some of the liability risk (whether that’s tax liability of civil liability – think slip-and-falls). They are both called general partners in this joint venture.
Many people want to invest in real estate but don’t want that level risk and they don’t want to do a bunch of work. They have a great job and make great money. They don’t want to quit that source of income but don’t have a lot of extra time. These investors might be interested in syndications.
A syndication is a fancy word to say that investors are pooling their money together. They subscribe to the deal and sign a subscription agreement. The investor who puts this deal together is called the principal, or sponsor. It’s this person who takes most of the risk. The principal usually has to give the bank a loan guarantee (though other people might give their guarantee as well). This guarantee is a personal promise to pay the bank back even if the company that owns the property fails to do so. This is good for the other investors, because this aligns the principal’s interest with theirs – don’t fail in the deal.
The principal finds the deal, negotiates the terms of the purchase, finds a loan from the bank, guarantees the loan, works with the attorney to start one or more companies that will own the property, runs the property for the entire ownership time, and finds investors to help fund the down payment and possibly initial rehab. The principal also has to follow strict rules from the Securities and Exchange Commission. In return, the principal gets an ownership share of the deal. This typically is from 10-70%. The other portion will go to the investors. The principal often asks for an acquisition fee, around 2% of the purchase price. Some also take a disposition fee of a similar amount with the deal is sold on the back end.
The investors bring the money to the deal. They are essentially buying shares (called units) in the remaining percentage ownership. If $100 needs to be raised and the principal is taking 50% of the ownership, then each $2 unit will be traded for 1% of the ownership ($100/50% = 2$ per 1%). Of course, deals are usually in the hundreds of thousands or millions of dollars to be raised. This is what we are talking about when we mention the split. We might say a 70/30 split. The investors’ split is listed first. In this way, 70% ownership is to the investors and 30% to the principal. To sweeten the deal further, the investors are also usually promised a special type of interest called a preferred return (or pref).
This is the name for the annual percent return on the investor’s principal. It’s a promised amount of return that each investor gets before the principal gets anything. If the principal does a poor job, the investors will at least get their money first, before the principal does. Pref is also a way for the investment to act a little like a loan. 7% would be a typical pref but it can go higher or lower. Pref is promised to the investors if the deal makes money, but can be paid back at any time. Usually it doesn’t gain interest if not paid. It just accumulates (cumulative but not compounding). If an investor put in $100 with a 7% pref, that investor is owed $107 after the first year, then $114 after the second year. It’s 7% of the initial investment added up after every year. It is the first thing that is due after the principal is returned at the end. Higher pref is more desirable for investors.
This is the amount of time that the principal is projecting to hold the deal. Syndications rarely are perpetual. Investors want to know at some point they will get their money out. A typical horizon is 5-7 years. Investors must be willing to have no access to their money for this time frame. Usually, the principal has full authority to decide to sell early or late, however.
At the end of the horizon, the principal begins marketing the property to new buyers. The principal tries to sell for the highest price possible. Once sold, the disposition fee might go to the principal, though I don’t charge this fee in my deals. I want the first profit to go to the investors in the form of their pref.
The first money that gets paid is all the creditors (bank, vendors, property manager) and any other bills. Getting all these paid might take a few months and these must be all paid before the deal is done. The next payment is the investors’ return of principal. This is a repayment of whatever money they put in. After this comes any pref that hasn’t been paid yet. The next part is the gravy, the best part of the syndication. It’s all the remaining profits, and if the principal has done a good job, it will be significant. It’ll get split as per the ownership split. The investors’ split will further be split into each investor based on their percentage ownership. Finally, this is all summed together and each investor gets a nice check. These are the only checks I love to write. Keep in mind there will be a substantial tax bill for the year, so don’t buy your boat just yet.
So, you see, there are a lot of details in a syndication. For this reason, the subscription agreement and private placement memorandum that the attorney puts together end up being around 100 pages. It’s daunting but it is important to read. The savvy investor will run it by their attorney. A good principal can walk the investor through these documents and explain them in detail. The terms I mentioned above are only for example. There are many more complicated ways to structure these deals.
The benefit of the syndication for the investor is the limitation of risk, which is typically limited to the amount of their investment and no more. They should be prepared to lose their entire investment. The downside is that they get no say in the management of the deal. The upside is usually a sizeable reward for their investment at the end. While not typical, my most recent syndication closed out with an 80% ROI after only 2 years! The syndication is a great investment vehicle for those who want to invest in real estate, and not just stocks, but don’t have time to manage a deal themselves.