What is a Real Estate Syndication?
Syndication is a structure of commercial real estate transactions that enables retail investors to purchase a fraction of a commercial real estate asset. In this structure, the person in charge of the business or "syndicator" forms a company and uses it to buy a commercial building. Second, they sell shares of the company to a group of investors whose combined capital is used to help fund the purchase of the property. Real estate syndications may be used for all types of business properties, including apartment, office, and retail properties.
Real estate syndicates are sanctioned by the Securities and Exchange Commission (SEC), which establishes a set of rules that exempt syndicators from securities registration rules if certain criteria are met. The most common types of syndications include 506(b) and 506(c) – which refer to the securities law section that authorizes them. While the details of trade real estate syndication transactions may vary, the roles of the parties involved are generally the same.
Key stakeholders in syndication: the General Partner and the Limited Partners.
In typical real estate syndication, there are two groups of investors, the general partner (GP) – also known as the developer or syndicator, and the sponsor (LP).
The General Partner is responsible for the arrangement and is responsible for locating, analyzing, financing, and operating the investment property. Practically, the GP is usually a real estate investment company or private equity firm, and they typically invest some of their own money in the transaction to demonstrate their good faith to investors. That's a very active part.
Limited Partners are investors who allocate their capital to the General Partner in the hope that they will receive a return on the capital. In exchange for their placement in syndication, limited partners receive shares from the property entity, which entitles them to a proportional share of the income and profits generated by the underlying immovable. Once the equity is allocated, the sponsor plays a passive role. They have no say in business decisions on ownership. Typically, it's the general partner or a third-party real estate management company. To fully understand this structure, it is useful to detail each role in more detail.
What Does a General Partner Do?
General partners manage the to-do list for a real estate syndication, including:
· Preparation of the syndication agreement
· Identifies compares and selects investment opportunities based on due diligence and benchmarking
· Organize funding for direct purchases and other expenditures
· Establish an investment strategy and business plan for every investment opportunity
· Promote the investment opportunity with prospective limited partners
· Manage ownership directly or supervise the property management team
· Manages taxes on syndications, insurance, and other financial liabilities
· Manage relationships with sponsors
· Management of the selling process at the time of selling the property
· In return for all such work, the General Partner shall be remunerated by a combination of fees charged to investors and a share of the profit on the sale
What Does a Limited Partner Do?
As outlined above, limited partnerships are passive investors. They provide part or all the capital needed to close a transaction but have no say in the day-to-day management of real estate assets. If there are disagreements between them, they are subject to the Operating Agreement, which is a document that details their roles and responsibilities of them and is to be signed as a condition of participation in the transaction. Syndication rules require Limited Partners to be "Accredited Investors" who meet certain annual revenue/net worth requirements. But it is generally the responsibility of the general practitioner to verify that he has the necessary income and assets to invest in a transaction.
How Does Real Estate Syndication Work?
Now that the key roles have been identified, let's illustrate the operation of a real estate syndication using a hypothetical example. Let's assume we find a grocery store anchored at the mall a meaningful analysis, we've identified it as a good deal, so we're proposing to buy it for $25 million. Once the offer is accepted, we will move quickly to establish a purpose. Then we negotiate debt with one of our preferred lenders who is willing to offer an 80% or $20,000,000 LTV loan. That means we must get the extra $5 million from Limited Partners. To do this, we have collected several key documents such as the syndication contract, the exploitation contract, and the subscription contract, and offer a memorandum and get down to business by sending them to investors we believe are interested in our deal. Often that must be done quickly because once the property is under contract, we must close within 60-90 days. Once the required equity is closed and we have done our due diligence to ensure that the property does not have major issues.
What is a Syndication Agreement?
A Syndication Agreement is a legal document that contains specific information on the roles, obligations, and liabilities of the Limited Partners and the General Partner. The details of a syndication agreement can vary significantly from transaction to transaction, but they generally cover the same information, including:
Voting Rights Within the Syndication:
This section describes each party's voting rights concerning major investment decisions, such as changes, renovations, and home repairs.
Profit Distribution for General and Limited Partners:
The syndication contract also describes profit allocation, disbursement schedules, and other essential details of the financial aspects of the relationship between the general partners and the limited partners. This section can be complicated, so it is always a good idea to consult to ensure that it is well understood.
Standards and Practices for Communication Between General and Limited Partners:
The syndication agreement sets the standards for the frequency with which syndication members must meet, for how long, and what must be discussed at each meeting. This establishes the level of confidence and transparency that sponsorship associates can expect when investing in real estate syndication. Potential Limited Partners must review and sign the syndication agreement before investing in the syndicated transaction.
What Are Acquisition Fees?
The general associates do the heavy lifting in an agreement, and they don't work for free. They charge fees for their services, some of which are designed to recover up-front costs, while others are transferred to third-party providers. Acquisition costs typically range between 1% and 5% of the size of the transaction.
What Are Asset Management Fees?
If members of a real estate syndication vote to manage the property at their own expense rather than engaging a third-party property manager, then the syndicate will charge an asset management commission that often amounts to 10% of the gross monthly income of the property (rent, parking fees, etc.).
What are Cash Flow and Appreciation?
The basic business plan of a commercial property is quite straightforward. Landlords charge rent to tenants for the privilege of renting the premises. This rental income is used to pay the property's operating and debt charges and, if something remains, it is distributed to investors (GP & LP). Over time, property rents tend to increase, resulting in increased cash flow. Where this is the case, the value of the property increases, which can make it possible to sell it at a price higher than the one paid.
What Are the Benefits of Real Estate Syndication?
For certified investors, there are many advantages to trade real estate syndication.
Keep in mind that Limited Partners are not involved in the daily operations of a property – they are managed by the General Partner, but, through their real estate investment, they have a right to a share of the income and benefits produced by the property. So, every income earned is passive income because they have nothing to do to earn it.
Suppose an investor has $150,000 of capital available for investment in the commercial real estate asset class. Instead of putting everything in one property, they could spread it over three different syndicated transactions, giving their portfolio an extra layer of diversification. Moreover, the evolution of real estate prices tends not to be closely correlated with that of the bond and equity markets. So that's another level of investment diversification.
There are two major tax advantages to unionized investing.
First, from an operating perspective, the accounting rules allow owners to take a certain amount of amortization each year to consider the physical deterioration of a property. Because amortization is a non-monetary expenditure, it reduces taxable income but does not reduce the amount of money available to real estate investors.
Secondly, if the investment group successfully sells the property for a profit, they can defer capital gains tax by reinvesting the proceeds of sales into a similar property through a transaction called "1031 Exchange". For both reasons, commercial real estate is generally a good choice for high-income individuals seeking to reduce their taxes payable.
What are the Drawbacks of Investing in a Real Estate Syndication?
Although they may come with many important advantages, a real estate syndication investment is not suitable for everybody. Possible drawbacks include:
Liquidity: Typical syndication has a 5- to 10-year mandatory holding period during which an investor is unable to withdraw his or her money. Even if that is the case, they may have to accept a substantial rebate.
Operational Control: Again, sponsors do not have operational control over the properties they are investing in. They delegate this responsibility to the General Partner, underscoring the need to ensure a solid record of performance.
Market/credit risk: Market risk is the risk that market conditions could become unfavorable to investment performance. For example, interest rates may increase, leading to higher vacancy rates and higher collection costs. Credit risk is the risk that a tenant may be unable or unwilling to pay rent, which may also affect a property's return.
Sponsorship Risk: The performance of an investment depends heavily on the skills and knowledge of the general partner directing the investment. Therefore, it is essential must have just had must have a good reputation and a track record. Every investor has his risk once, so it's up to him to assess both the risks and the benefits to determine the best property investment for himself.
Who Is Eligible to Invest in Real Estate Syndications?
Depending on how the specific syndication structure is used, the eligibility criteria for investing are different. A 503(b) syndication is available for accredited and sophisticated investors, whereas a 506(c) is open to accredited investors only.
How to Become an Accredited Investor
The qualified investor is an individual with an income greater than $200,000 for two previous years, or a combined income greater than $300,000, or the person must have more than $1,000,000 in single equity or joint equity with a spouse regardless of his or her principal residence. While no governance body "accredits" investors, companies offering investment opportunities turn to the SEC guidelines to determine whether a person is accredited. At the end of the day, it's up to the company that provides the investment opportunity. As recently as 2020, the SEC updated the guidelines for qualified investors to include personal investors, who possess certain professional qualifications, persons considered qualified employees of a private fund, and registered investment advisors. This change has opened the door for individuals with professional credentials, such as doctors, lawyers, and other professionals.
How to Become a Sophisticated Investor?
The Sophisticated investors as persons or enterprises with "sufficient financial and commercial knowledge and experience, to enable them to assess the merits and risks of forward-looking investments. As in the case of accredited investors, a person does not receive a certificate that qualifies him as a prudent investor. Rather, it is through the SEC guidelines and the discretionary power of a private company that an individual is considered sophisticated.