There are many ways to finance a real estate project. Borrowing is popular because interest is tax-deductible, and lenders do not have managerial control over the project. A financing strategy called real estate syndication deals with raising the equity capital for a deal, and it has some unique characteristics that merit consideration. In this article, we answer, “What is commercial real estate syndication?”. We also give tips for raising capital through commercial real estate syndication (CRES), consider how to structure CRES, and examine how sponsors profit from syndication.
What Is Commercial Real Estate Syndication?
A commercial real estate syndicate is a group of private investors who pool their money to finance a large real estate project. Syndication allows each investor to participate in a project that requires a down payment larger than any of the investors could individually afford. Alternatively, even if you, the sponsor, could afford the down payment, you might choose syndication if you didn’t have the requisite skills and knowledge to operate the property. By leveraging your partnerships, syndication allows you to close more deals at the same time.
The commercial real estate syndication sponsor is responsible for identifying investment properties, arranging the financing, acquiring the property, and overseeing the management of the day-to-day rental operations. Whereas the sponsor is quite active in the syndicate, investors are passive and play little role in the deal other than investing. For tax purposes, the money that investors earn is passive income.
Tips for Raising Capital Through Commercial Real Estate Syndication
It’s important to observe the proper etiquette when a sponsor attempts to raise capital through syndication.
1. Mind Your Relationships
As a sponsor, you have to be a bit of a salesperson when recruiting syndicate members. It starts with being honest and straightforward – investors are looking for realistic reassurance, not exaggeration. You must also be attentive. Don’t be late for appointments, whether in-person meetings or phone calls. Keep your promises – do what you said you would do, when you said you would do it. Always remember that real estate syndication is a relationship business.
2. Elevate the Investor’s Interests
You must demonstrate that the investor’s interests come before yours. Imagine you are pitching to your grandmother, who is willing to risk her life savings because she trusts you. This should keep you from sinking investor money into problematic deals.
3. Comply with Regulations
Below, we go into how to structure a real estate syndication deal. The point here is to understand that syndication involves many rules, regulations and laws. You must strictly comply with these, lest you risk your investors’ capital. For sure, hire a seasoned attorney who can guide you through the process, and prepare the proper documents and disclosures. An attorney can protect you as you close the deal. Real estate syndication laws vary from state to state. We have provided a short list of resources:
- New York State – Real Estate Syndication Laws
- California – Real Estate Syndication Laws
- Texas – Real Estate Syndication Laws
Video – Understanding Real Estate Syndication Law
Lard the Deal with Incentives
Investors are easier to recruit if the sponsor offers some incentives. For example, these include:
- Identifying a property that is available at a below-market price, in a good neighborhood with good employment statistics
- Providing a return on investment superior to that available on more prosaic investments, like IRAs and REITs
- Finding properties with net operating upside, possibly through higher rents and lower expenses
- Establishing a conservative exit strategy
- Provide an impressive track record, either your own or that of a partner
Be Prepared to Answer Investor Questions
The three top questions investors are likely to ask are:
- Will I get a guarantee? The investors must be clear that there does not exist a money-back guarantee. Of course, that’s also true of 401(k)s and the stock market, so it shouldn’t come as any surprise to investors. Nonetheless, you should point out that the property collateralizes the investment and insurance covers physical damage.
- How long until I get my money back? The exit strategy will indicate the number of years before the sponsor plans to sell the property. An answer in the three-to-five-year range should please most investors.
- What are the tax benefits? First establish the fact that you aren’t a tax professional. Advise the investor to consult a CPA for expert tax advice. Nonetheless, you can make clear that the investment qualifies as passive income. And, that part of the investor’s cash flow receives shelter due to depreciation and expenses. It’s also possible that the investor can use IRA funds to invest in the syndicate, thereby sheltering all the income.
How to Structure A Real Estate Syndication
Sponsors typically structure a syndicate as either a limited liability company or limited partnership. The sponsor serves as the Manager or General Partner, while the investors are members or limited partners. An LLC Operating Agreement or LP Partnership Agreement governs the syndicate. The agreement specifies each party’s rights. This includes voting and cash distribution rights, and the rights of the sponsor to collect management fees. Of course, the agreement specifies numerous other details as well, and it can be quite lengthy.
The sponsor will usually contribute about 5% to 20% of the required equity capital, with investors putting in the rest. Syndicates usually pay preferred returns to investors first, then to the sponsor. Generally, investors are looking for a return in the 8% to 12% range. If the syndicate promises a 10% preferred return to investors, the sponsor can only collect a return after the investors receive their 10%. After paying the preferred returns, the syndicate and sponsor split the income and capital gains cashflows on agreed upon terms.
Commercial Real Estate Crowdfunding
The 2012 Jumpstart Our Business Startups (JOBS) Act created a new way to form a real estate syndicate, called crowdfunding. Commercial real estate crowdfunding allows a sponsor to publicly solicit investors online through a specialized website called a crowdfunding platform. Only accredited investors can participate. This method allows a much wider pool of investors to join a syndicate, allowing the sponsor to raise capital faster and easier. In 2017, commercial real estate crowdfunding raised $464 billion in capital.
Crowdfunding allows investors from all over the country to participate in commercial real estate syndication. Sponsors can rely on automated investor management tools to track and communicate with their investor networks. The crowdfunding platforms often support much of the workflow for investor acquisition and verification. The platforms can package the deals, generate the required documents and gather signatures.
Video – How to Structure a Real Estate Syndication
How Sponsors Profit from Real Estate Syndication
A sponsor can receive compensation in several ways:
1. Acquisition Fees
The sponsor is responsible for identifying the property, performing due diligence and structuring the deal. For these services, the sponsor typically charges an acquisition fee between 1% and 5% of the total project size. Alternatively, the sponsor might receive a flat acquisition fee.
2. Asset Management Fees
The sponsor earns 1-5% of the property’s gross monthly income in asset management fees. The sponsor receives these fees to manage the property and the syndication deal, including updating the investors on the latest developments. This also includes overseeing the management of the property and organizing the tax preparation. However, the actual management of the property falls to a property management company that the sponsor oversees.
3. Equity Participation
This is the income cash flow. The sponsor’s cut is due to his equity stake in the project and the expertise he brings. The sponsor will usually receive between 5% and 50% of these cashflows, with the remainder going to investors on a pro rata basis. The equity flows also include the proceeds if the syndicate sells the property. The syndication agreement might give the sponsor a different split for the rental income and the proceeds on the property’s sale.