Real Estate Syndication 101

By: Jeff Heybruck & Saxby Morehead

Recently, I was having dinner with a group of peers when a member of our party mentioned he had started working with a new real estate investment group.

The group was offering an approach he hadn’t seen before – real estate syndication – and he wanted our opinion on the offering. I was surprised to find that another member of our party, despite being quite successful in business, also had no experience with these types of investments.

This interaction gave Saxby and I the idea that this topic might be of interest to other business owners and investors as well.

What is a real estate syndication?

A real estate syndication is when a group of investors bundle their money and resources together to invest in a real estate project. Shopping centers, land, and apartment complexes are a few examples of the types of investments available through real estate syndications.

What is the difference between a general partner (GP) and limited partner (LP) in a real estate syndicate?

Typically, there are two types of owners: general & limited partners. Note that this is not a legal definition, but more of a practical one. In most deals, the general partner is usually the developer, promotor, or organizer of the investment. The limited partners are typically the folks who put up most of the equity, although some parties could participate on both sides (i.e., a developer whose partners also invest equity alongside the other investors).

The primary role of the general partners (GPs) in a real estate syndicate is to execute the business plan, make major decisions on behalf of the syndication and facilitate strong returns for the limited partners (LPs).

The role of the LP is to provide a portion of the resources needed to acquire the asset. In return, the LP receives ownership shares in the investment.

How is a real estate syndication deal typically structured?

LPs, or equity partners, typically receive “interest” on their contributed equity one of two ways: preferred return or a waterfall based on a targeted Internal Rate of Return (IRR). While they have fallen out of favor lately, preferred return deals used to be the standard structure. In these deals the investors would receive a “preference” on distributions of X% of their contributed capital.

Distributions of cash would first cover the accrued but unpaid preference (calculated by multiplying the preference rate times the invested equity), then any excess would reduce the equity balance by returning some cash to the LP investors. Once all equity had been returned, the preferred return was now 0 (X% times $0 capital invested = $0) so the developer or promotor would begin receiving a cut of the cash distributions.

Lately, we are seeing more offerings using IRR waterfall structures. In a waterfall, the investor members receive 100% of the cash distributed until they have reached a specific, stated IRR %, say 8%. Once the investment has generated an 8% IRR, the developer or GP starts participating in the cash distributions after that at say, 70/30 up to a 12% IRR, then 60/40 up to a 18% IRR, then 50/50 thereafter.

There is no set rule; it is completely up to an investor to ensure that they receive an appropriate return for their risk and a developer to choose a model that will get them enough interested LP investors so that the equity those LPs put into the deal is sufficient.

What are some common types of real estate investment opportunities?

Most investment opportunities that we see fall into three categories:

• land plays
• build/development deals
• value add opportunities

While this is by no means an exhaustive list, it probably covers most of what investors would typically see and each option is described more below:

• Land plays focus on buying a tract of land that is undervalued, in the path of progress, or likely to appreciate quickly for whatever reason. It can either be vacant or have a structure on it and may or may not be generating any form of income. Examples include a key parcel that fills in the rest of a city block, a foreclosed subdivision banked until the housing market recovers, or the purchase of a less- than-market rent building to generate enough cash to cover the holding costs.
• Build/Development deals are probably what most folks think of when they hear “developer.” These are investments where the developer identifies a piece of raw land, finds a tenant or end user, entitles the property, does the site work and any vertical construction, and then either leases or sells the finished product. Examples include turning a farm into lots for a subdivision, building a shopping center, or converting an old warehouse into apartments.
• Value Add investments take an existing property that has issues and fixes those issues. Maybe a property isn’t getting the attention it needs because an owner is focused on other things. Or the façade, signage, and landscaping is dated causing the occupancy to suffer. Perhaps the previous owner never reinvested and signed leases with poor terms. A good value add developer can identify these issues, creatively solve them, and generate massive returns in just a few short years.

What are the phases of real estate syndication?

Regardless of the type of investment described above, most real estate investments have a similar life cycle, including syndications. This can range from weeks to decades. For purposes of this article, we’re going to skip all the prequalification, due diligence, and other work that goes on behind the scenes before the developer brings the opportunity out for investors to review and decide if they are interested.

• Acquisition – To no one’s surprise, this is when the property is acquired, and the life of the investment begins as far as the LPs are concerned.
• Construction/Improvement – Depending on the type of project, this stage is when the project is probably at the riskiest. It may be cash flow negative, meaning great sums are being poured into moving dirt or erecting steel, but no rental or sales income is flowing yet. Debt may be at its peak here. For Value-Add plays this is when the parking lot is getting restriped, new awnings, landscaping upgrades, and leases are being reworked.
• Stabilization / Operation – Once Construction is done most investments move to some form of operations. In apartments or large retail, it’s called stabilization. This is where the dramatic outflows of cash for tenant upfits and construction cease and the monthly rent and expenses become more normal (or stable!). In a subdivision development project, the utilities and site work are done; the roads are in. Now we’re selling lots each quarter to a homebuilder who is building houses.
• Sale / Close-out – Opposite of Acquisition – this is the eventual exit from the project. On a Land Play this is probably the first substantial income to be realized from the project. For a Value Add, this is also where the big payoff is. With a lot development project, it’s when the last lots are sold, homes are finished, and the roads are accepted by the DOT. At this stage anyone involved is looking to count the money and check the “score”, that is, they want to see what their rate of return was.

Is real estate syndication risky?

As with any investment, there are inherent risks to investing in real estate syndications. Looking at real estate syndications specifically, the most challenging decision for individuals will be who they chose to invest with. It is important for the investor to fully vet and research the real estate syndicator before moving forward with an investment. Once funds are invested with the syndicator, LPs have no say in how the syndicator operates. Furthermore, once the money is invested, there are no options to pull cash out in the middle of the project. Investors are locked in for the entirety of the investment.

Real estate investing can be tricky and there is a LOT more to it than we could possibly list in just one article. Considering how successful my colleague was in his career to date, I was very surprised he had never been exposed to several of these terms and concepts. Saxby and I felt it would be a good idea to share some concepts with our readership and hope you too can maximize your investment potential using whatever vehicles give you the best return for the least risk.

Happy investing!