Although investment can be a solo sport, it’s often much more satisfying (and lucrative) when it’s a team effort. To unlock the real power of passive investment, you need to know about syndications. In this article, we will look at what real estate syndications are, why they matter and how they relate to making passive investments in real estate.
What Are Real Estate Syndications?
In the world of passive real estate investments, a syndication is the pooling of capital and resources among multiple investors to achieve a common goal, specifically investing in properties.
By working together, a group can acquire otherwise unobtainable assets by leveraging significant financial power to get deals done that no individual on their own would be likely to finance — or at least, not without huge personal risk.
Many, if not most, apartment complexes are bought through syndications. So are other things such as office buildings, shopping centers, hotels, self-storage facilities, and even Broadway shows.
But a syndication is not just about a shared pool of money.
The people who form syndications bring more than their wallets to the table. They also weigh in with their experience and knowledge, often including valuable learnings from past deals.
The collective balance sheets & track records of the group lead to everyone benefiting from the ability to get better loans and better loan terms.
So, a syndication leverages combined financial power and collective experience to produce a group that can operate more effectively than the individuals in it could alone. The right syndication is greater than the sum of its parts.
How Does A Syndication Work?
A syndication is a group of people who will be involved in a real estate investment deal. We can think of them as a cooperative team.
Every team needs some leadership, and that’s where sponsors come in.
Sponsors — also called syndicators or general partners — are the people who run the investment deal. I’m using the plural because most deals need more than one person in the leadership role, though it’s possible for a single sponsor to be in charge of a deal. The sponsors’ role starts with getting a property under contract and then reaching out to investors to join the group. Individual sponsors often handle different tasks ranging from the identification and acquisition of properties to the operation and ultimate disposition of the property.
Investors — also called limited partners — are everyone else in the syndication. As I’ve written about before, investors can be either sophisticated or accredited.
The syndication is therefore all of the sponsors and investors for a given deal.
The deals themselves can be structured in different ways. The most common method is for the sponsors to create a company, usually an LLC.
The investors essentially purchase an interest in this company as their way of buying into the deal.
The Three Deal Components
I recommend to all investors that they vet the three essential components of any deal:
- The Sponsors
- The Market
- The Deal
Of these, being sure of the sponsors is the most important, as they play such a crucial role in things working out (more on that in a moment).
If all of those things check out, the investors buy into the LLC created by the sponsors. Then they sit back and wait for their quarterly or monthly “distributions” (payouts) while the sponsors operate the deal. It usually takes 3–9 months before such payments start if the deal is operating successfully.
The Risks For Sponsors
The sponsors who create the LLC carve out a portion of the company for themselves as compensation for a successful deal.
How this is structured will vary from deal to deal, but this arrangement should recognize the effort required on behalf of the sponsors.
Keep in mind that most sponsors:
- spend years to learn the market and build relationships.
- find opportunities for investments.
- negotiate the deals.
- place non-refundable money (AKA at-risk capital) early on in the venture.
- sign on the loan documents.
- manage the day-to-day mechanics of the asset.
- review the financials regularly.
- create monthly or quarterly reports on the performance of the property.
- put their reputation at stake.
Sure, the investors are putting something on the line, too. But once they’ve done their checks and bought into the LLC created for the syndication, that’s essentially it.
The sponsors, however, are the captains of the team — the CEOs of the deal. If they fail, everyone loses.
The risk and effort are greater for the sponsors, and that’s why there must be fair compensation for them.
Naturally, investors should be satisfied that this compensation is commensurate with the sponsors’ experience and with the returns they’ve produced for investors in the past. Sponsors don’t just get to write themselves a blank check.
Typically, sponsors take a 20%–30% interest in the deal.
The Lifecycle Of A Real Estate Syndication
Here are the typical stages for a syndication. As I said above, most of the work is done by the sponsors (it’s called passive investment for a reason!):
1. The sponsors find a property, get it under contract, and then reach out to investors.
2. The sponsors inform investors about the offering and send out legal documents for review. Often, they conduct an online presentation to discuss the offering.
3. The investors complete the paperwork and then fund the investment. (Sponsors often invest in their own deals, and this is a prerequisite for any deal that I invest in.)
4. The sponsors close on the deal and then manage the operations of the property.
5. The sponsors arrange the sale of the property, hopefully providing the projected results.
Legal Documentation For Syndicated Investments
As you might expect, no deals happen without the right legal agreements being in place. An attorney appointed by the sponsors sets up the syndication which should include the following items:
1. An Operating Agreement for a single-purpose entity that will acquire the property. It contains the rules the entity will follow throughout all of the business’ operations.
2. A Private Placement Memorandum (PPM) that goes into more detail on the structure of how the entity will function and conforms to Securities and Exchange Commission (SEC) rules. Inside the private placement memorandum, there are lots of warnings; it calls out many of the things that could go wrong with the deal. It also has disclosures on fees, the operating agreement, and the structure on which this business is going to run.
3. A Subscription Agreement, which documents the amount of ownership the investor is purchasing in the entity.
4. An Investor Questionnaire, which asks the investor several questions to ascertain whether they are sophisticated or accredited. Or, if it is a 506(c) offering, an affidavit must be signed by a CPA or attorney, verifying the investor’s accredited status. (I discussed 506(b) and 506(c) offerings in my article about sophisticated versus accredited investors.)
5. A Business Plan, which describes the sponsor’s plan and how the company will be profitable.
Are Syndications Always Necessary?
Strictly speaking, no. Sometimes it doesn’t make sense to create a syndication if only 2 or 3 people are involved and they’re all active in making the deal work. In such cases, a “joint venture” is often acceptable and you can avoid the effort of creating a syndication.
But if there are 5 or more people involved, or even if it’s a smaller group but one of the people is going to be much more active than the others, a syndication is likely to be essential. Make sure you speak with an SEC attorney for guidelines on this.
Tax Considerations For Syndications
Syndications usually work out to be a very tax-efficient investment, especially for people with high yearly incomes. That’s because investors don’t pay tax on distributions. Taxes are calculated annually, based on the company’s gains or losses— and these gains often aren’t realized until a property is sold.
Most syndications are taxed as a partnership. This means the company files a tax return at the end of the year but does not pay corporate tax. They provide a K1 document to each partner that shows their portion of any profits or losses in the company and the partner is responsible for the taxes.
Due to depreciation, these K1s usually show a loss during the time that the property is owned. So even if an investor receives distributions during the year, it’s likely they will be showing a loss on their tax documents. I’ll illustrate that with a quick example:
Syndication Tax Savings Example
Say that you invest in a syndication that holds a real estate property for 10 years. In each of those years, you receive distributions but due to depreciation on the property, you do not pay taxes on that cash flow.
When the property is eventually sold, you’ll need to recapture the depreciation on the asset. This means that in addition to paying capital gains tax on any profits from the sale, you will need to “recapture” (pay tax on) all the depreciation you accumulated over the course of the deal.
Based on current tax laws, recapture is taxed at a lower rate than what high-income earners pay on their ordinary income. Plus, you’ll get the benefit of holding on to that money during the years of the deal instead of paying it year by year as if it were part of your normal salary. Resulting in a tax-efficient investment.
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