What Is A Syndication Anyway?
Many commercial real estate investments happen through a syndication. It is interesting that one of the definitions of a syndicate in the Merriam Webster dictionary is “a loose organization of racketeers in control of organized crime.” That makes me chuckle. More broadly a syndication is simply the pooling of resources to accomplish a common goal. If you have been on a commercial airplane then you have been part of a syndication. Chances are you were not interested in paying for all the costs of operating that flight so you and all the passengers put your money together or “syndicated” a flight, with the help of the airline.
Real estate syndications typically involve a team of active real estate professionals bringing together passive investors who do not want to learn the details of real estate investing. Many investors enjoy their current careers or love to spend their time doing other things. They understand that real estate offers diversification, strong returns, and different risk profile from traditional stock investments. Hence, they invest in syndications. The syndication structure allows passive investors to place their capital with syndicators, deal sponsors or operators. These terms are often used interchangeably. It is the job of the operator or syndicator to research the market, find the deal, close the transaction, implement the business plan, and operate the asset until it is sold.
There is no standard format, structure or setup for real estate syndications. Indeed, often a lot of loose associations exist between parties. For this reason it is important to establish a clear understanding about what you are getting into, with whom, and for how long.
Questions to Ask
- Do You Trust The Operator?
- This is the most important question that you need to ask yourself. It also has several layers of questions beneath it. There are many ways in which an operator can make or break the deal. They may be incompetent or inexperienced. They may be overly excited about the market cycle and may be buying every deal in sight. Alternatively, they may be extremely sharp, prudent and may have done the right research and analyses. Whichever camp they fall into sometimes market forces turn in unforeseen ways and result in unexpected results. Good operators at times deliver below projections and inexperienced operators sometimes outperform. Ask whether they were invested in the 2008 downturn and how they weathered that period. Ask what lessons were learned then that they apply today.
- Above their skills, temperament and ability to perform, the bigger question is whether you trust their moral character. Do you feel that the operator will do the right thing for you when faced with a really difficult decision? This is a high bar and not an easy answer to arrive at. It is hard to judge human character. Experienced professionals such as secret service agents and court judges get it wrong all the time. Speak to as many people as you can. Ask other investors, brokers, sellers, people in the industry what they think about the operator that you are considering. Ask objective questions. Ask the same questions in different ways. Is there a consistency in the answers? Are there any pieces of the story that do not add up for you? Ask the operator to tell you about those deals that did not go as planned. It is easy to do the right thing when everything is going well. True character is revealed when times are tough. Be careful.
- How Aligned Is The Operator With You, The Investor?
- The most obvious means by which an operator is aligned with the investor is the fact that if they do not deliver results or act immorally then there is little chance that they will stay in business. Look for operators that have been in business for a significant period of time. Good operators have a brand to protect and a reputation to defend. They do not want to make short term decisions which will impact their investors, their reputation, and their credibility negatively in the long term. It takes a long time to build a reputation and only a few poor decisions to destroy it.
- Many operators show additional alignment with investors by co-investing their own capital alongside the investors in the deal. This is a good indicator of vested interest but it is far from an iron-clad guarantee of anything. Even in cases where operators have their own money invested in the deal there is some opportunity for a divergence in alignment between the operator and the investor.
- Consider this scenario: an operator bets big on the project and puts in a large portion of their net worth into the deal. A year into the holding period they have a major family emergency that requires significant funding. The business plan execution is just getting under way yet the operator now has a motivation to sell the deal early even though the best thing for the passive investors is to hold and sell in a few years. Be careful what you wish for. Yes, typically syndicators putting personal funds in the deal is better than them not doing so. This does not, however, guarantee absolute alignment.
- Who Is Providing the Loan Guarantees?
- Most syndicated real estate loans use non-recourse debt financing. This means that even if things do not work out as planned passive investors or limited partners are not liable and their personal assets cannot be used to fulfill the loan obligation. Effectively the property being acquired serves as the collateral. What you may not know is that the banks still do require someone to guarantee that the investment will be managed in a conscientious manner, without fraud, misappropriation or environmental degradation. The operator has to make these guarantee and they are typically backed by showing a total net worth greater than the loan amount being borrowed from the bank. Should there be any illegal acts the principals who provide the above guarantee are indeed personally liable.
- It is important to understand who is providing these guarantees. The net worth requirement is cumulative so more than one individual may be on the hook. Some operators are just starting out in the business and may not have the personal balance sheet to provide such a guarantee. If this is the case they outsource the risk by finding an individual or group of individuals who fulfill the net worth requirement in exchange for a one-time fee or an equity share in the deal. Operators who personally guarantee the loans clearly have more to lose that those who shift the risk to a third party. The loan guarantee shows better investor alignment.
- Who Is Paying the Up Front Costs?
- Before a deal gets presented to investors a lot of money has to change hands. Earnest money deposits, often to the tune of hundreds of thousands of dollars, have to be put in escrow. Lenders often require that their application processing fees and third party diligence costs be paid up front. There are legal costs to establish the entity which will be the vehicle for the investment. Additional legal fees are required to draft and negotiate the entity agreements such as the Purchase and Sale Agreement, Operating Agreement, the Private Placement Memoranda, etc. All of these fees typically are paid up front and are not recoverable should the deal not close. It is helpful to understand who pays these costs and what exposure your contribution to the investment has should the deal not cross the finish line. Will you get your money back in full should this transaction not close? Will the funds be held for another similar deal?
- How Is The Investment Structured From a Legal Perspective?
- Each investment is structured slightly differently. There is no standard for real estate syndications. The majority of syndications are organized as a limited liability company (LLC) or a limited partnership with the operator principals having day to day operational control or being the General Partners (GP) and the cash investors having no day to day operating control or being Limited Partners (LP). This structure enables easy distribution of profits to individual investors as income in these legal structures is not taxed at the entity level but flows through to the investors’ individual returns. Other investment structures exist such as Tenants in Common and Delaware Statutory Trust which have advantages related to deferring taxes but come with significant limitations with respect to control, how funds can be contributed or withdrawn, and how much capital expenditure can be put into the property to add value. The complexities of these latter structures tend to outweigh their benefits resulting in LLCs and Limited Partnerships being most commonly used.
- The biggest disadvantage of real estate investments is that they are typically illiquid, meaning that your capital will be tied up for some significant period of time and you cannot easily exit the investment. Your rights as a limited partner and other specifics of the legal structure including potential premature exit will be spelled out in the offering legal agreements. Make sure you understand what you are allowed and not allowed to do before you invest to avoid surprises and uncomfortable conversations at a later time. You need to read the legal documents to make sure you know what your rights are and how everything will work. As tempting as it may be, do not skim through the legal documents. Read them in detail. It will save you money.
- What Are The Projected Returns To You After All The Fees Are Paid?
- Beyond the legal structure you need to understand how ownership equity is divided in the deal. You need to be clear about the percentage of the profits that you are entitled to on an annual basis as well as when the property is refinanced or sold. What are the various fees that the operator is charging? Typical syndications often involve some or all of the following fees: Asset Management Fee, Acquisition Fee, Disposition Fee, Construction Management Fee, etc. Ask about these and make sure to understand both the numerator and denominator of the fee calculations. Are the property returns being projected calculated before fees or after fees? Some investments are structured in a way where limited partners get a certain preferred return which gets paid out before the operators get paid but also could limit the upside to limited partners. Other investors have a simple 70:30 percentage split of profits to LPs and GPs respectively, or some variation thereof. There are no wrong structures and there are no bad questions. Make sure you understand how the cash waterfall flows and when it fills your buckets. It needs to work for you.
- What Are The Assumptions Used To Arrive At The Projected Returns?
- Every real estate investment will have two key components of the return:
- The cash on cash return which gets paid out annually
- The split of profits when the property is refinanced or sold
- Where the majority of the return comes from is a range that defines the personality of the deal. Some deals have a high percentage of the return that comes from the annual cashflow distributions (cash on cash return) while the building does not appreciate much in value. This will result in a low return percentage from the profit split on sale. Other deals may involve a lot of construction and renovation work up front. This usually results in low cash on cash returns in the early years but high profit split upon sale, since a lot of value is added to the property through the renovation phase. Some deals see the returns come from both of these components.
- All operators have a financial model which they use to predict future performance. As with any model there are many assumptions made. Recognize that any property can be made to look good in a model with faulty assumptions. Try to understand what key assumptions drive the various components of the return. Ask questions about these and try to gauge how conservative or aggressive the various assumptions are.
- For example, high cash on cash returns stem from operating expenses being significantly lower than the revenues that the property generates. Dig into that—is this situation true at the property prior to acquisition? What levers is the operator going to pull to further drive revenue higher while keeping expenses relatively low? Why does the syndicator believe that they can operate the asset better than the current owner?
- On the other hand a high property valuation in the future depends on a high net operating income (NOI) and a low cap rate. Where are these numbers prior to purchase? What is the plan to improve these numbers to favor of the investors? What specifically is the operator planning to do to increase the net operating income over time? Is this plan credible? Cap rate on the other hand is an elusive concept which measures investors’ willingness to pay for a cash flow stream. Predicting this in the future is extremely difficult. Conservative underwriters almost always plan for a future cap rate that is higher (worse) than the current cap rate. Today, as we slowly exit the global pandemic, we are in a relatively low cap rate environment as there is a shortage of housing nationally and investors are bullish on real estate. Because of this it is prudent to estimate that cap rates will be higher in the future than they are today.
- Other important assumptions in the model are the rent and expense escalation projections in each year of the investment hold period. If the operator is projecting a dramatic jump in rents in year 2 then it is important to understand what factors will drive that. Is there a significant renovation plan in place backed by capital expense dollars to accomplish this plan? Does the local economy stand to benefit from a marked influx of new jobs, population, income growth that is expected to drive the projected rent increase? Is there a wave of household formation on the horizon which will put upward pressure on rents? On the expense side—is there a lasting global supply chain disruption which pushes cost of goods and labor higher, or is it a temporary phenomenon? These are some of the factors that have outsize effects on the returns model and the assumptions around them need to be understood.
- Every real estate investment will have two key components of the return:
- Why Does This Deal Make Money? What Makes This Particular Deal Unique?
- Each investment opportunity has a story. Try to understand why the operator is particularly thrilled about this opportunity. What is the deal thesis and business plan? What needs to be true for the operator to be able to execute the plan? Are there any unique circumstances which make this deal work? How does this deal stand out from the many others that the operator has evaluated recently? Listen carefully and see if the story, the plan and the probability of success make sense to you. Do you believe that there is a high likelihood that events will unfold as presented. Why or why not? Ask the sponsor for any sensitivity analyses on cases where things do not go as planned. Discuss those and ask objective questions. What dominos need to fall for this opportunity to deliver the returns that you are expecting?
- What Is the Market Doing And Does It Support This Deal?
- But what is the market? In real estate the market is very local. As a result there are many, many real estate markets. It is often a mistake to equate national headlines to what is going on in the town where your operator is about to tie up millions of dollars. The key is to investigate further, examine the facts carefully about the big picture and your specific location, and then make your own conclusions. Also understand that markets are cyclical. They do not always go up. They do not go down forever either. The difficulty is understanding where in the market cycle you are. Nobody can predict the top or the bottom. Good operators plan for numerous market outcomes.
- On a micro level it is important to understand what is going on locally in that state, in that county, and in that municipality. Is the state creating a business-friendly environment which in turn attracts employers and population inflow? Or is there a slow but steady exodus of people and jobs? Have home prices appreciated here over time? What is the relative cost of single family homes compared to one apartment in the complex that your group is acquiring? If homes are significantly more expensive it gives people at least one reason to rent—the cost of living in an apartment will be more affordable. Are property taxes extraordinarily high giving building owners little opportunity to make a profit? Are there government programs, contracts, jobs, or military installations which favor your investment somehow? If the population is declining very slowly and your asset is in a stellar location, there still may be a reason to invest in the deal. You have to take in all the inputs and judge for yourself.
- On a macro level it is important to understand whether “the real estate market” is hot or cold. As the saying goes “A rising tide lifts all boats.” If there is job growth and income growth then the economy is doing well and people generally have confidence in going out and forming new households. This means they are looking to perhaps take that first step and rent an apartment. If interest rates are relatively low then investors are incentivized to take on debt for business ventures including real estate investment. These conditions will likely help your investment. However, many experienced operators find ways to make money in a down cycle. I have spoken to many people who say “The market is too hot so I am out” or “The market is too cold so I am out.” These people often miss years of upside. You need to ask good questions to understand the deal thesis.
In summary, there are many questions that you need to answer before you e-sign those legal documents, wire your money in, and join the ranks of passive real estate investors. You need to understand and be confident in the operator, the deal and the market. I strongly recommend you vet them in that order. Find a trusted operator and they will bring you good deals in markets that will work. The operator or syndicator is the key to the puzzle.
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