A real estate syndication is when property investors come together to finance a real property investment. There can be a few real estate investors involved or even hundreds. The parties pool their financial resources, and other real estate investing resources to form the syndication. Real estate assets such as mobile parks, self-storage units, apartments building, office buildings, and shopping centers are typical real estate syndications.
There are typically two parties involved in a real estate syndication, (1) The Syndicator/ Sponsor, (2) The passive investors. Both parties contribute differently to the syndication process.
A real estate Syndicator/Sponsor, is responsible for finding the investment, the investors, negotiating with the seller, and developing the business plan. Real estate syndicators also are responsible for the due diligence on the potential property acquisition. They underwrite the deal and arrange the financing.
A syndicator is responsible for the execution of the entire process from start to finish. At the close of the deal, the syndicator is the one in charge of asset operation. Their main priority is executing the business plan and giving passive investors returns.
Passive investors are responsible for the financing of investment capital. Passive investors earn passive income through real estate syndications.
As a passive investor they are eligible for income from the investment either on a monthly or quarterly basis. They also, may receive a return if the property is sold or refinanced.
In addition to passive returns, there are tax benefits, appreciation, and equity pay down attached to the investment. The property’s value gradually increases over time, bolstering an investors’ return on investment (ROI).
Ways Syndicators raise funds
- Online: Online syndication is similar to real estate crowdfunding. Rather than only marketing to investors the sponsor knows, they can use an online marketplace to solicit investors, using the marketplace’s tools to manage their investment and portfolio.
- Offline: Offline syndication occurs when sponsors use their own networks to solicit deals. They use their own personal connections to get the funds needed to purchase properties.
- Private: Private syndication is a combination of online and offline syndication.
Common Real Estate Syndication Terms You Need to Know:
- Issuer: The company (Set up specifically for the purpose of conducting the syndication) that offers the investment and will own the property. In most cases, both the Sponsor and the Investors will own a portion of the Issuer.
- Offering: The deal itself. The Issuer “offers” the investment on the terms set forth in the Offering (typically in a document called the Private Placement Memorandum or Private Offering Memorandum). For example, the Offering may be to give Investors 80% of the Equity in the Issuer in order raise capital.
- Equity: An interest in the profits or losses of the Issuer. Syndication Investors typically receive an “equity interest” in the Issuer based on the amount of their investment. The more they invest, the bigger the piece of the Issuer’s “Equity” they receive.
- Regulation D: A federal Securities & Exchange Commission (SEC) regulation that provides exemptions under which Issuers can raise capital without the need for filing a costly and time-consuming “Registration Statement” with the Commission. Regulation D Offerings allow Issuers to raise money from Accredited Investors and, in very limited circumstances, a restricted number of non-Accredited Investors. Regulation D Offerings are further divided into Rule 504 and Rule 506 Offerings.
- Accredited Investor: A term defining the people allowed to invest in Regulation D Offerings. Accredited Investors must either: a) have a net worth greater than $1 million (not including the equity in their personal residence); or b) make more than $200,000 per year (or $300,000 per year, jointly with a spouse).
- Crowdfunding: Refers to an Offering conducted under SEC “Regulation Crowdfunding.” In a Crowdfunding Offering, an Issuer can raise up to roughly $1 million from an unlimited number of investors, but there are limits on how much each investor can invest based on their income or net worth.
- Preferred Return: Often times, the Investors will receive an annual or quarterly payment equal to a certain percentage of their investment, prior to profits being split by the Passive investors and the Sponsor. These payments are the Investors’ Preferred Return.
**Sponsoring or creating a real estate syndication can be complicated and doing it the wrong way can have severe consequences. Make sure to consult with an attorney that specializes in securities law and specifically that of syndications or “private placements” for real estate projects. The rewards of a properly completed syndication can be great, but the consequences of doing it incorrectly could also be significant.
The most common structure for syndication:
Syndication deals are generally set up as a limited liability company (LLC) structure or a partnership structure. The sponsor is the General Partner (GP) and the investors are the Limited Partners (LPs). This structure enables joint ownership in the commercial property based on the amount of equity contributed by each partner. The GP has full authority and decision rights while LPs are passive investors only. As an investor, it’s important to read the operating agreement and offering documents to clearly understand your rights as a limited partner.
Waterfall from operations (returns on capital.)
Any income is paid to sponsor to reimburse for any funds owed to the sponsor, and any interest due on those amounts for the time the sponsor has left their money in the transaction.
Once the sponsor is paid back, any cash available for distribution is used to make up any arrearages in the preferred return paid to the investors, and the current preferred return that should be paid to the investors.
Once the sponsor and the preferred returns are dealt with, any remaining cash available for distribution is split according to the percentage split included in the operating agreement.
Waterfall from a capital transaction (return of capital)
When there is a return of capital, generally as a result of a refinance or sale, it is common for the investors to get a priority return up to the amount of their original investment. Then any fees due to the sponsor are paid. Remaining cash available for distribution is then split according to the percentages found in the operating agreement
Ways the sponsor can be paid:
Acquisition fees is a fee the sponsor receives for the formation stage of the offering. The fee compensates the sponsor for time, effort, and expertise used in obtaining the investment opportunity. Most often the acquisition fee is a percentage of the money invested in the offering. Typical fees range from 5% to 10% of the money raised. Sometimes, the acquisition fee is stated as a percentage of the price of the property acquired when there is a specific property. Generally, this method uses 2% to 5% of the price of the property.
Ownership interests is when the sponsor takes a direct ownership interest in the offering as a form of compensation for bringing the investment opportunity to the market. The investors put up all the money for a percentage of the company and the sponsor gets the balance. Typical ownership interest splits at formation range from 20% to 50% for the sponsor. Taking ownership interests directly at formation can cause a tax problem for the sponsor because if the ownership interest has an immediate ascertainable value, it is treated as ordinary income and is taxable when received.
Asset management fees is when the sponsor receives payment for managing the company, apart from managing the real estate which they may not actually do. The asset management fee is an expense allocated to the company, not to the property. Asset management fees are sometimes calculated as a percentage of the revenue the company produces, usually 1% to 2% of the income the company receives. In other situations, the asset management fee is based on the amount of money raised from investors. If the company raised $2 million dollars, the asset management fee might be 1% to 2% of that amount, paid annually. Some sponsors set the amount of the asset management fee as a fixed annual dollar amount, paid monthly or quarterly.
Share of operational cash flows
When the company generates cash flow that can be distributed, it is common that the sponsor shares in the cash flows. Frequently, the sponsor will receive between 20% and 50% of the cash flows generated by the operations of the company.
Share of refinancing proceeds
When a property is a value add, rates go down, or a new construction project there can be a time when the property can be refinanced to return the investors all or a portion of their original cash investment without selling the property. The sponsor may get a share of the refinancing proceeds.
It is common for the refinancing proceeds to go directly to the investors as a return of capital. If the proceeds exceed the investors’ original investment, the sponsor and the investors may split any excess, or use any other agreed to formula. Sometimes the equity split between investor and sponsor adjusts as to give the sponsor additional equity as this point.
Share of sales proceeds
When the sponsor has an ownership interest, the sales proceeds are split on a pro rata basis. But when the sponsor is only sharing in the cash distribution, it is likely that the investors will get a distribution of sales proceeds to equal a return of their original investment, as a priority distribution. Then the balance of the cash available for distribution is split between the investors and the sponsor. It is common for the sponsor’s split to be between 30% and 50%.
William M Mason, Esq. is an attorney and founding partner of Mason and Mason PLLC. He has over 25-year experience, representing individuals, corporations, and lenders in the disposition, acquisition, and financing of residential and commercial real estate.
This article is not meant to be legal advice and should not be relied upon in making any financial decisions. It is a short summary of tax planning strategies and may not include all applicable requirements to your situation. Each individual’s situation varies, and it is recommended that you retain an attorney, or CPA to review your individual situation.
