When you spend time speaking with other people interested in Real Estate you may come across the word "Syndication". Not sure what that means? You're not alone, but a growing number of people are discovering this type of real estate investing and it's benefits.
Definition of syndication
1 : an act or instance of forming a syndicate or bringing something under the control of a syndicate
//real estate syndication
2a : the act of selling something (such as a newspaper column or television series) for publication or broadcast to multiple newspapers, periodicals, websites, stations, etc.
//the syndication of news articles and video footage
b : the state of being syndicated to multiple newspapers, periodicals, websites, stations, etc.
// a popular TV show that has made millions in syndication
So since we aren't talking about Seinfeld reruns here, we will focus on the first definition.
Here are some of the most common questions asked by passive investors learning about syndication. These questions are focused on value-add apartment syndication.
1. What is syndication?
Syndication is the pooling of resources to purchase a large asset, such as an apartment building. The investors are passive, limited partners (LP) and the other partner is the General Partner (GP), also called a sponsor or syndicator. The General Partner is the active partner that finds, analyzes and creates the business plan.
2. Who can invest in a syndication deal?
These types of deals are marketed under SEC regulations 506(b). This means that the deals can be shared with accredited investors only who we have a prior relationship with.
3. What is an accredited investor?
To be an accredited investor, a person must have an annual income exceeding $200,000, or $300,000 for joint income, for the last two years with expectation of earning the same or higher income in the current year. An individual must have earned income above the thresholds either alone or with a spouse over the last two years. The income test cannot be satisfied by showing one year of an individual's income and the next two years of joint income with a spouse. The exception to this rule is when a person is married within the period of conducting a test.
A person is also considered an accredited investor if he has a net worth exceeding $1 million, either individually or jointly with his spouse, excluding your primary residence.
4. What is a Limited Partner (LP)?
The limited partner is a passive investor in the deal. They have limited liability and their risk is limited to the amount that they have invested, no more. All other assets are protected. They cannot be sued, are not listed on the loan and best of all, they are not responsible for any active management of the property.
5. What kind of returns can I expect from an apartment syndication?
Typical returns are 8-10% annually with an internal rate of return (IRR) of 16-22%. The average rate of return is obtained by taking the total return over 5 years divided by 5, this is typically higher because it does not take into account the time-value of money, as the IRR calculation does. (Would you like to have $100 of today's dollars today or in 5 years?)
.
6. What is a preferred return?
The "Pref" or preferred return is the percentage given to the limited partners first, before the general partners are paid. This is typically 8%. This means that the first 8% return on an investment will go entirely to the limited partner. After the LP are paid, then the general partner will start to receive distributions as well. This helps align interests with the general partners.
7. When will I get paid?
After we close on the property, distributions begin approximately 1 month later. The preferred return is paid either monthly or quarterly. These distributions can be directly deposited into your bank account.
8. What kind of tax implications are there to this kind of investment?
Fortunately investing in real estate is tax-advantaged, and syndication is no different. The sponsor will be deducting property taxes, loan interest and depreciation and you will benefit from this as well. The depreciation is accelerated since the asset is not held for more than 5-7 years. You will receive a K-1 statement from the general partnership in March. It's not unusual for the K-1 to show a paper loss, despite a monthly or quarterly income, on average $8000 on a 100K investment. Even better, any supplemental loans or refinance events are reviewed as a "return of equity" so they are not taxable events.
And lastly, at the time of sale of the property, there may be an opportunity to do a 1031 exchange into another property that the sponsor purchases, thereby deferring your capital gains.
9. What is a supplemental loan?
When the property is purchased, the GP will start to add value to the property as outlined in the business plan. This is done through renovations, improving operations, decreasing expenses and increasing rents as improvements are completed. Since a commercial property is not valued on comparable properties, or "comps", as in residential real estate, the value is calculated based on net operating income (NOI) divided by the local capitalization rate, or "cap rate". When the value of the property is increased, the GP can return to the bank with a higher value and either refinance the property or obtain a second loan on the property (called a supplemental loan). This allows you to pull out equity from the investment, which is returned to the investors. This typically occurs after the units have been renovated, which takes 2-3 years on average.
10. What is the typical holding period for this type of investment?
We target 5 years for most deals. At that time the original principal invested as well as any profits are distributed. Sometimes it makes sense to sell in year 3 and if a downturn occurs the hold time can be increased to 7 years. There is no rule that the property must be sold in 5 years even if the market is down. This protects your investment.
11. What if there is a downturn in the economy?
As described above, we would not sell in a down market, but rather hold the property and continue to pay the preferred return to the limited partners. Fortunately, apartments are protected during a downturn for several reasons. Class B assets hold their value and occupancy rates because people moving out of homes or more expensive apartments need affordable housing. Our rents are targeted below the top of the market for this reason. In the downturn of 2008 the value of apartments decreased 3.5% while the residential market decreased 34%.
12. What are the risks of apartment syndication?
The risks are outlined in the Private Placement Memorandum (PPM). This document is 100+ pages long and much of the wording is regulated strictly by the SEC, down to the placement of text and the font. This is to educate the investor. This type of investment is not insured or protected by the government. However, the strength of the syndication team is of utmost importance. If your team has strong partners and a proven strategy to add value to apartments in good neighborhoods your risk is lessened. Also, consider that the money we place in mutual funds or the stock market is similarly not insured or protected. We don't have to sign a PPM to place money in Wall Street, but maybe we should.
13. Does the syndicator or sponsor invest in their own deal?
To promote alignment of interests many sponsors will invest alongside the limited partners on the LP side of the deal.
14. What is the minimum investment?
Most deals have a 50K minimum investment and increments of 5K thereafter.
15. Can I get my money back before the property is sold?
This type of investment should be considered illiquid. Having said that, as partners, if you encountered a hardship we would work with you if possible.
16. Is it possible to utilize a 1031 Exchange into a deal?
No, you cannot 1031 into the deal but it may be possible to use the 1031 Exchange to move into another deal with the same operator.
17. Can I use a Self Directed IRA or Solo 401k to fund this investment?
Absolutely! One of the best ways to build wealth is to maximize your tax deferred vehicles to invest in real estate. This allows you to keep the proceeds from the investment tax free as well until withdrawal (or forever, if you use a Roth). The SD-IRA has something called UBIT tax whereas the 401k does not.
18. How is the property renovated while people are living there?
When the property is taken over, there will be vacant units even if the occupancy rate is at 95%. For example in a 400 unit building there would be 20 vacant units. The renovations are started on those empty units, rents are raised following the improvements. The following month, when leases are coming up, we will offer the newly renovated units to those residents who are renewing, and start renovating their vacated unit along with any other units that are vacated. This is repeated until all of the units are renovated. We expect that the improvements are so dramatic that retention and new lease signups will be high.
19. What is the timeline of purchasing an apartment building?
Once the property is under contract, the due diligence phase lasts about 60 days.
On completion of this, the marketing deck is created, including the sensitivity analysis, business plan and expected returns. There is an investor conference call and we start to raise equity. Investors reserve their spot, review the PPM, sign and fund. This takes about 6 weeks. After funds have been received we close on the property 2-3 weeks later. The distributions start about 60 days later.
20. How will you communicate with me?
You will receive monthly updates via email on progress of the investments. We will identify how many units were renovated, the rents collected and other details. Quarterly property management financials will be available as well. You can also track your investment on our Investor Portal. In March you will receive a schedule K-1 statement for your taxes.
21. What is a sensitivity analysis?
This shows different scenarios for occupancy and where the breakeven point will be if there is a decline in occupancy or if rents are not as high as projected. Fortunately most of our scenarios allow occupancy to go down to 75% and still break even. In the 2009 financial crisis, third party data showed that in one of the submarkets in Dallas where we have 6 apartment communities the lowest occupancy level was 85%.
22. Are the forecasts conservative?
Absolutely. A good sponsor will be focused on preserving investor's capital and make sure they underpromise and overdeliver. Key metrics include rent projections - they should be under the top of the market after renovations. The capitalization rate on exit should be forecasted as higher than when the asset was purchased, which is more conservative as an exit strategy.
23. What are the fees paid to the syndicator?
The returns forecasted should be after fees have been paid. The sponsor is paid an acquisition fee, which is typically 2% of the purchase price, paid on closing. This covers all of the sponsor's costs to find and acquire the deal. The other common fee is the asset management fee, which is also 2% and is based off of the monthly income/revenue from the property. This fee is for execution of the business plan and overseeing the property management. Industry averages are 1-3% for both of these fees.
24. What is a split an a waterfall?
These terms relate to the division of returns to the limited and general partners. If the split is 70/30 in favor of the LP, then the limited partner receives 70% and the general partner 30% of revenue after the preferred return is paid. This applies to all distributions or capital events. A waterfall refers to a change in the split if a certain return is achieved, typically measured by IRR. For example, a typical split would be 70/30 then change to 50/50 once the IRR hits 15%. This rewards the sponsor for achieving a higher than expected return
.
25. What is a PPM?
The Private Placement Memorandum is required by the SEC and has several parts. It tends to be 100-150 pages long. It contains a description of the offering, the risks and includes the partnership agreement, investment summary and subscription agreement. The entire PPM can be daunting and the risk section can be alarming (similar to a Surgeon General's warning) by highlighting every possible risk that could happen. While it is true that there is risk with every investment, it's important to look at the track record of your sponsor and the history of multifamily investments in a severe downturn. Also, the banks will not lend 10-30 million dollars to a sponsor unless they are experienced, have a good business plan, conservative underwriting, have adequate insurance and have the property condition report completed by outside experts highlighting what fixes are to be made before taking over the property.
26. What kind of apartment buildings do you look for?
The best building is one that has good structure but is older and needs some cosmetic improvements. This is a "value-add" opportunity. This is typically a 1980-1990 era building, B class, and we look for these in good neighborhoods, A class areas. We then focus on rebranding (new name), new website, new property management team and renovations of the property and the units. Adding some technology like Nest thermostats, keyless entry and an Amazon locker pick up site is appealing to the younger residents. We also focus on intangibles such as monthly gatherings that can foster a sense of community and improve retention of residents.