Investment grade commercial real estate assets are incredibly expensive, which means they are likely to be unaffordable – in a direct purchase scenario – for all but the most well funded individual investors. Fortunately, there is another method through which individuals can invest in commercial properties – by allocating capital to a commercial real estate syndication.
In this article, we are going to describe what a syndication is, how they work, and the risks and benefits of allocating capital to one. By the end, readers will have all of the information needed to determine if a commercial real estate syndication is suitable for their individual investment strategy.
At First National Realty Partners, we are a private equity firm/commercial real estate deal syndicator who specializes in the purchase and management of grocery store anchored retail centers. If you are an accredited investor who would like to learn more about our commercial real estate syndication opportunities, click here.
A Short Explanation of Real Estate Syndications
In real estate investing, an easy way to think about a real estate syndication is as a structure that allows individual investors to purchase a fractional share of a commercial property. In a typical deal, there are two groups of investors, the general partner (GP) and the limited partner(s) (LPs). Each has a distinct role to play in the administration of a commercial real estate investment.
The general partner is the deal leader. Their job is to find properties to purchase and to manage all of the leg work that goes into arranging the financing, performing the due diligence, and managing the cash flow once the acquisition is complete. This is a job that requires a significant amount of experience and dozens of deal repetitions to be effective.
The limited partners are passive investors. This means that they allocate capital to the general partner – who uses it to purchase properties – but otherwise have no role in the day to day management of the property.
Put simply, a syndication is a structure that allows individual investors – who don’t have the capital or desire to purchase a property directly – to earn passive income through fractional ownership of a commercial investment property.
Projected Returns in Real Estate Syndication Investments
As the deal leader, one of the general partner’s most important jobs is to raise capital from individual investors. As part of this process, they need to be able to clearly communicate how much potential return investors can expect to earn from being involved in the deal.
To accomplish this, the general partner creates a pro forma projection of cash flows that lays out the property’s expected income and operating expenses for each year of the expected holding period. The potential return is usually expressed in the form of two metrics, the internal rate of return (IRR) and/or the equity multiple.
The IRR is a rough approximation of the expected annual return on a percentage basis while the equity multiple is a number that informs investors of the multiple or their original investment that they can expect. For example, an equity multiple of 2.00X means that an investor could expect to receive two times their money back in the deal.
Clearly, one of the primary concerns in an investor’s mind is that they want to earn the maximum return possible. For this reason, it is important to understand the elements that drive the amount of the return.
Elements of Real Estate Syndication Returns
As a general rule, there are three elements that impact a property’s potential return. As part of their due diligence process, real estate investors should review each of them.
A typical commercial real estate investment has a predefined holding period, usually somewhere in the three to ten year range. Broadly, investments with shorter hold times tend to have a lower return than those with longer holding periods. This is because there is a longer period of time from which to collect cash from the property.
The business plan and hold time for every rental property is unique so investors should study it prior to allocating capital to make sure they are comfortable with it.
Cash on Cash Returns
Cash on cash return is a metric that measures that amount of cash an investor receives on an annual basis relative to the total amount invested. For example, if an individual receives $10 from a $100 investment, their cash on cash return for that year would be 10%.
Another way to think about the cash on cash return is that it is associated with the property’s performance on an annual basis. It is driven by key factors such as rental income, taxes, property management fees or utilities, and can vary on a year to year basis. Generally, the cash on cash return accounts for a small share of the total return delivered.
Asset Sale Profits
If the cash on cash return makes up a small portion of the total return, the gain on sale is where the bulk of profits are achieved. For example, if a property is purchased for $1MM and sold for $1.5MM, the gain on sale is $500k.
Real estate prices tend to go up slowly over time, so when a property is held for a longer period of time it has a greater chance for more appreciation. This point further underscores the importance of holding period in determining the total return.
How the Types of Syndication Structures Affect Returns
The above three elements are not the only things that impact the amount of a deal’s return. One other major factor to consider is the structure of how profits are split between the general partner and the limited partner(s). There are three structures that are commonly observed.
In a straight split, the cash flow and profits produced by a property are split cleanly between the general partner in the limited partner(s). The respective percentages can vary by deal, but it could be a 50/50 split or it could be split relative to the amount of capital that each group contributed to the deal. These details are usually outlined in an investment’s offering documents which highlights the need for investors to read them carefully.
To entice potential investors, general partners may offer a “preferred return” to limited partners. The details of this arrangement can vary from deal to deal, but it generally means that all of a property’s cash flow and profits will go to limited partners until they have achieved a certain return amount – say 8%. Once this threshold has been met, the remaining cash flow and profits are split in some proportion between the GP and LP(s).
A distribution waterfall is a structure that is commonly found in private equity investment opportunities or those found on crowdfunding platforms. But, it can also be complex so it is important to understand how they work.
In a typical waterfall, there may be 2 or more “steps” at which point the split between the GP and LP(s) changes. Changes in these splits are triggered when the investment’s return reaches certain thresholds. To illustrate how a waterfall may work, an example is helpful.
Suppose that a general partner found a multifamily property that they liked with a purchase price of $10MM. Based on their underwriting, a lender is willing to provide a loan for $8MM, which means that the general partner needs to raise the remaining $2MM from investors. Of this amount, suppose that the GP themselves put in 10% or $200,000 and they raise $1.8MM (90%) from the limited partnership.
The GP is responsible for structuring the waterfall and they must do so in a manner that balances their own return requirements with those of their investors. In other words, the structure should incentivize the GP to deliver a high return while rewarding investors with a strong return.
For example, a common waterfall structure may pay all investors a preferred return until a threshold of 8% has been met. Above that level, the cash flow split may be 20% to the GP and 80% to the LPs until a threshold of 12%. Above that, the split may change again to 30% for the GP and 70% for the LPs. In such a structure, the GP is incentivized to deliver a high return because their share of the profit goes up each time they reach the next return threshold. And the higher the return, the more investors earn, a win/win.
It is important to note that returns can be measured using a number of different metrics but IRR is most common. In addition, every waterfall is unique. Their structure is outlined in the offering documents.
Summary on Real Estate Syndication Returns
Commercial real estate properties are expensive and they require a significant amount of time and expertise to operate. For this reason, it is not likely that they will be purchased by individual investors or even a small group of investors. But, this doesn’t mean that individuals can’t invest in this asset class.
Individuals who meet certain income and net worth requirements can invest in a commercial real estate syndication, which is a deal structure that allows individuals to partner with a professional deal manager to earn passive income.
For individuals, there are a number of benefits to investing in a syndication including: passive income, tax benefits, depreciation, and the ability to achieve portfolio diversification by investing in a wide range of deals.
The downside is that investors are still exposed to real estate market risk in addition to the asset management risk associated with choosing the right deal manager. For this reason, the manager’s track record should be evaluated carefully to ensure they have a history of running profitable deals.
In a syndication, there are a number of factors that impact returns including the purchase price, holding period, annual performance, and the sales price. In addition, the split arrangement between the general partner and the limited partners is a major driver of returns.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.