By Dr. Jim Dahle, WCI Founder
A real estate syndication is an illiquid but passive way for accredited investors to invest in real estate. As a syndication investor, you won’t be getting 3 am toilet calls and you will never have to talk to a tenant. You don’t even have to ever lay eyes on the property. Once you make the decision to invest, your role in the investment will be limited to cashing the checks sent to you by the syndication. Who doesn’t want mailbox money?
While a syndication can be done with as few as two investors, a much more common structure is the typical legal maximum of 99 investors. Like with a mutual fund, the investors have banded together to enable some economies of scale, hire professional management, and acquire larger and more profitable properties than they would be able to afford by investing alone.
A typical property might be a $15 million large apartment complex. If each of 99 investors contributes $50,000 in capital, the syndication will have about $5 million in equity. The syndication will then borrow another $10 million and purchase the property. The syndication may renovate the apartments over 1-2 years (a “value-add” strategy), renting them out for higher rents after renovation and thus increasing the value of the property. The investors will receive income payments every quarter and then after five or ten years the syndication will sell the property and the investors will receive a check for their share of the proceeds. If the business plan goes as expected, that check will include a nice profit on the investment.
The Business Structure of Real Estate Syndications
Most syndications are set up as limited partnerships or limited liability companies. The person in charge of the syndication is generally referred to as the general partner (GP), operator, or sponsor. The investors are known as limited partners (LPs), members, or investors. The GP often must sign personally for any loans on the property, and thus has an elevated degree of risk compared to the LPs. While the LPs can (and occasionally do) lose their entire investment, their loss is limited to the amount of capital they have invested. While a syndication in trouble will often have a “capital call” asking the investors to contribute additional capital, there is no requirement to do so. However, if an LP refuses to do so, their share of the business may be diluted and if enough LPs refuse, the property may be foreclosed on and all of the capital may be lost.
GPs often have some “skin in the game” and so are also LPs in the syndication. In addition to their share of the profits as an LP, they are also entitled to fees for their efforts and an additional level of risk as the GP. A typical fee structure would be 1% a year of the equity plus 20% of the overall returns above and beyond a certain “preferred return,” such as 6% per year. This portion of their fees is referred to as the “promote” or “carried interest.” If the GP is also the property manager, they may also charge fees for that.
Regulations of Real Estate Syndications
In response to the Great Depression, a number of important investing laws were passed, including the Securities Act of 1933. Prior to that time, a real estate entrepreneur had very few regulations governing their ability to market a property to potential investors. Starting in 1933, all new investment offerings had to be registered with the Securities and Exchange Commission (SEC). The idea was to prevent fraud, but this additional level of regulation certainly put a damper on the ability to really form syndications. However, there was an exception. If you raised the capital through private solicitations from people you had a previously existing relationship with, you did not have to go through the expensive, time-consuming, and onerous process of registration. Basically, you just couldn’t advertise these opportunities. One had to learn about them through word of mouth (the hard part), establish a relationship with the sponsor (the easy part), and then one could invest. The JOBS Act of 2012 relaxed these registrations to the point where syndicators could advertise their investments, but only to accredited investors. As a general rule, the legal definition of an accredited investor is someone with an income of at least $200,000 a year for each of the last two years (or $300,000 a year combined with a spouse) or investable assets of at least $1 million. These amounts have not been adjusted for inflation for many years.
Regulations aside, my definition of an accredited investor is someone who can evaluate the merits of an investment on their own without the assistance of a financial advisor, accountant, or attorney and can afford to lose their entire investment without it affecting how they live their financial life in any significant way. I also suggest people not only meet both of the financial criteria, but double each of them. With investable assets of at least $2 million AND an income of at least $400,000, it will be much easier to diversify a portfolio of private syndications and to be able to lose $100,000 in a syndication without a significant effect on your financial life.
Syndicated investments are often called “Reg D Offerings,” after regulation D of the 1933 Securities Act. Rules 504 and 506 are the ones that generally apply, specifically 506(b) and 506(c).
Under 506(b), an investment may have an unlimited number of accredited investors and up to 35 sophisticated, non-accredited investors but cannot advertise.
Under 506(c), an investment may be advertised, but all investors must be accredited.
There is another important piece of legislation that affects private investment companies, the Investment Company Act of 1940. Under rule 3(c)(1), a company that has no more than 100 accredited investors (the 99 investor rule) is allowed to sidestep certain disclosure and registration requirements. Under rule 3(c)(7), a company that has no more than 2,000 qualified purchasers can also side step these requirements. However, qualified purchasers are generally significantly wealthier than accredited investors ($5 million versus $1 million) and so most syndications follow the 99 investor rule for ease of administration.
Some private investments, particularly large evergreen funds, simply elect to register with the SEC to get around the 99 and 2,000 investor rules. While there is some additional expense and hassle, the ability to raise money from more investors and advertise to get them makes it worth it. These funds often still require accredited investor status and occasionally require qualified purchaser status.
How a Syndication Differs from Other Private Investments
Other private investments may be marketed as a fund or as a Real Estate Investment Trust (REIT). A fund is simply a number of syndications (such as 10-20) all placed into the same investment. Like syndications, these are usually limited partnerships or limited liability companies, they just own more than one property. Investors are also often asked to invest before they know which properties the fund will be purchasing. With a fund, you have a known manager but unknown properties. One reason investors choose individual syndications over funds is that it allows them to know exactly what they’re purchasing in advance.
A REIT is a specific legal structure. Rather than sending its investors a K-1 tax form each year like a partnership, a REIT sends a 1099-DIV tax form. While this makes it difficult for investors to use depreciation from this investment against passive income from other investments, it dramatically simplifies tax filing as there will not be a requirement to file taxes in other states. Think of a REIT as a fund with a different legal structure, although many funds have elected to structure themselves as a REIT for tax purposes. Most publicly traded real estate companies are structured as REITs, but not all REITs are publicly traded. Publicly traded REITs are often grouped together into mutual funds, providing easy diversification and liquidity. REITs, particularly publicly traded REITS, are dramatically more liquid than syndications.
What Are the Biggest Benefits of a Real Estate Syndication?
The main benefits of syndicated investments include:
- Access to larger, potentially more profitable properties
- The ability to analyze the property prior to the purchase
- Pass-thru depreciation
- Low correlation with overall markets
- Passive income
- Potential to do a 1031 exchange to defer depreciation recapture and capital gains
What Are the Biggest Downsides of a Syndicated Investment?
The main drawbacks of syndication include the following:
- Illiquidity: You may not have access to your money for many years.
- Leverage: Almost all syndicated real estate investments are significantly leveraged and poor management can result in a complete loss of capital.
- Lack of diversification: Your entire investment is generally in a single property, however by teaming up with other investors, you can own small pieces of multiple syndications rather than putting all of your money into one large property that you own by yourself.
- Fees: In order to incentivize the GP to do the work and take on additional risk, they must be well-compensated and those fees must by necessity come from the LP returns.
- Lack of control: The GP holds all the strings and decides how to run the property and when to sell it, no matter what the tax consequences to the LPs might be. Once you invest, you are along for the ride for multiple years.
How Do Real Estate Syndications Make Money?
The main way that a syndication makes money is the same way that any real estate investment makes money. It generates income through rents and it appreciates in value. When leverage is used, the paydown of the mortgage produces an additional source of return. The tax benefits (depreciation mostly) can also substantially increase the investor’s after tax return.
Given the illiquidity, lack of diversification, and leverage, most syndications must project returns of 12%-18% in order to attract investors. Done well, they often achieve those returns and in a favorable macroeconomic environment, can even exceed those returns. However, syndications often underperform the rosy pro-forma produced by GPs trying to raise money. Run poorly, syndications can even produce a total loss of capital thanks to leverage. Private investments are also fertile ground for incompetent, rank beginners, and even fraudsters. Like everything else in investing, higher returns are generally correlated with higher levels of risk. If you want 15% returns, the cost is the potential to lose it all.
Syndications can be a profitable way to invest a portion of your real estate portfolio. However, they have significant downsides that must be understood prior to investing. Be a real accredited investor, not just one who meets the legal definition of one if you choose to invest.