10 Things to Look for When Comparing Real Estate Syndications
- May 03, 2017
- Author: Tom K Wilson
The increase in popularity of real estate investment syndications (crowdfunding) in the last few years has presented huge opportunities to investors looking to invest in multifamily and commercial properties for passive income. As syndications are a way to pool money from multiple investors to accomplish a common investment goal. In real estate, this typically involves pooling equity to purchase a property, frequently leveraged with a commercial loan, with the intention of improving or holding it for appreciation and cash flow.
With opportunity, however, comes the need to know what to look for when comparing opportunities. I have compiled 10 of the most important factors to look for in a syndication when evaluating them in order to make the most informed and successful investments possible.
1) QUALIFICATIONS. Check to see if the syndication requires you to be an accredited or sophisticated investor. Most syndications are structured under one of two SEC Regulation D, exemptions:
a. 506(b) only requires an investor (up to 35 per deal) to be sophisticated, which is simply a borad definition meaning an investor possess sound financial education. An unlimited number of accredited investors can be also be accepted. 506 (b) only allows sponsors to offer investments to their existing client base, therefore, if you are interested in deals from any syndicator, make sure that you establish a relationship, which generally begins with signing up on their website.
b. Exemption 506(c) investments require all investors to be accredited (minimum net work $1M exclusive of home or income requirements of $200K single, $300K married) and also unlike 506(b) requires verification, generally done via a CPA or 3rd party service.
2) TRACK RECORD. Syndications are passive (investors cannot manage and have no liability), so it is extremely important that the sponsors have a proven track record and knowledge of the industries and regions they are choosing to invest in. Good syndication sponsors often partner with experts when bringing new asset classes and MSAs to their investor pools. Due diligence is key, and sponsors should be able to clearly articulate why they like a deal and what sort of risk mitigation exists.
3) PREFERRED RETURNS. Many stabilized properties are generating revenue via rents collected from tenants, and the sponsors of these syndications will often structure a preferred return to investors. This return represents an annual return on the principal amount invested by the investor (i.e. 8% returns on $100,000 investment = $8000/year). This return accrues at a predetermined rate, and must be paid before any profit-sharing takes place upon the sale of the property. Some deals will have a set preferred return pegged to an investor’s initial investment, while others will establish this return as a percentage of actual net cash flow received.
4) DIVIDENDS. Often confused with preferred returns, dividends differ in that they are the actual payments made during the hold period of a deal. These are often paid out monthly or quarterly. Certain value-add deals that require increasing occupancy or rehab work may delay paying dividends until the cash flow of a property is sufficient to cover these payments. Dividends are ultimately paid at the discretion of the sponsor, and can be interrupted due to unexpected expenses or vacancies that arise during the course of the holding period.
5) TAXES. Sponsors should actively work to reduce the amount of taxable income received from real estate deals. For example some sponsors will perform cost segmentation studies and bring a 3rd party to accelerate depreciation, further mitigating taxable obligation on dividends paid out. Dividends are generally tax reported on a form K-1, which should include the depreciation sheltering.
6) REPORTING PERIODS. Sponsors should provide progress reports on the status and management of the property during the course of the investment. Some provide extremely detailed tenant by tenant accounting, and others simply provide a cash flow or overview of the property. Ask a sponsor for previous reports to see what kind typically provide. Generally they are provided at the same interval as the dividends being paid (monthly or quarterly).
7) PROFIT SPLIT. A common feature in syndication deals is for the net profits upon sale to be split with a portion going to the sponsors and the balance to the investors. These profits are what are left over after closing costs and fees are paid, preferred returns are paid, and original investor principal is returned. The percent of profits that get split among investors can vary significantly on a deal, based on risk, sponsor involvement, and overall return structure.
8) SPONSOR FEES. Syndication sponsors derive compensation from one or more of the following categories.
A. UPFRONT FEES. These fees are built into the amount of money raised and help compensate sponsors for time and money invested to find and vet the deal, secure the loan and structure the syndication for the investors. There is no formal terminology, but this money is commonly called sponsor fees, acquisition fees, or due diligence fees. These are separate from 3rd party fees from entities such as lenders, attorneys, title companies, and inspectors.
B. ASSET MANAGEMENT FEES. During the hold, some sponsors will take compensation for mangement time and costs incurred to keep the property running successfully. These are typically a percentage of rents collected or net cash flow that the syndication receives and are paid at the same time as dividends to investors.
C. PROFIT SPLITS. Typically, most of the value of a property is derived at the time of the sale. A successful syndicator is incentivized by a percentage of net profits to help close a deal out and maximize profits. These will vary by deal, but should be high enough that the sponsor is motivated to invest the time and effort throughout the entire hold period to maximize returns.
9) EXIT PLAN. Syndications are illiquid and are passive investments, meaning sponsors decide how to execute the plan and when to sell the property. A good sponsor will have an exit plan that has a projected hold period or range of years, contingent on market conditions. Most value-add deals will be shorter in length due to most of the value being created in early years. Many stabilized property deals will be longer in order to take advantage of increasing rents, equity build up through debt payoff, and stabilized cash flow.
10) VOTING RIGHTS. Most syndications are structured through an LLC. The LLC buys and sells the property with the sponsors being Class B managers. The Class A investors will be formally included in the company/operating agreement of the LLC that outlines their percentage of ownership. Some LLCs will give members voting rights as well, which can be used for large decisions such as changing management, restructuring returns, or dealing with death or transfer of existing members. It is important to understand the type of rights you have as an investor and what types of transferability, if any, your shares have.
This is just a sampling of the many components of a real estate syndication that savvy investors should be knowledgeable when evaluating opportunities. Knowing how syndications are set up and function will allow you to make the best investment choices.