Individual investors who want exposure to commercial real estate assets typically face two obstacles, purchase price and expertise. With regard to price, a typical institutional grade commercial asset is very expensive – for example, the typical grocery store anchored retail center in our portfolio has a purchase price in the ~$25 million range. With regard to expertise, it requires a significant amount of labor and operational expertise to find, analyze, and operate a commercial rental property. Fortunately, there is a deal structure that solves both of these issues for investors – it is known as a syndication.
In this article, we will discuss what a syndication is, how it works, and the risks and benefits of investing in one. By the end, readers will have the information needed to determine if this popular commercial real estate investing structure is a good fit for their own objectives.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers and we do so through a syndicated structure. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is a Real Estate Syndication?
A syndication is a commercial real estate deal structure that allows individual investors to purchase a fractional share of a commercial real estate asset.
In this structure, the deal leader or “syndicator” forms a corporation, LLC, or partnership and uses it to purchase a commercial real estate property. Then, they sell shares in the corporation, LLC or partnership to a group of investors whose combined capital is used to help finance the purchase of the property. Real estate syndications can be used for all commercial property types including multifamily apartment buildings, office, and retail properties.
Real estate syndications are sanctioned by the Securities and Exchange Commission (SEC), which defines a set of rules that exempt syndicators from securities registration rules as long as certain criteria are met. The most common types of syndications are known as 506(b) and 506(c) – which is a reference to the section of securities law that permits them.
Though the specifics of commercial real estate syndication deals can vary, the roles of the parties involved are typically the same.
Essential Players in Syndication: the General Partner and the Limited Partners
In a typical real estate syndication, there are two groups of investors, the general partner (GP) – also known as the sponsor or syndicator and the Limited Partner(s) (LPs).
The General Partner is the deal leader and it is their responsibility to find, analyze, finance, and operate the investment property. Practically, the GP is usually a real estate investment company or private equity firm (like us) and they typically put some of their own money into the deal as a show of good faith to investors. This is a very active role.
Limited Partners are the investors who allocate their capital to the General Partner with the hope of receiving a return on it. In return for their syndication investment, Limited Partners receive shares of stock in the ownership entity, which entitles them to their proportionate share of the income and profits produced by the underlying property. Once the capital is allocated, the Limited Partner is a passive role. They have no say in the operational decisions for the property – this is typically left to the General Partner and/or a third-party property management company.
In order to understand this structure thoroughly, it is helpful to break down the specifics of each role a bit further.
What Does a General Partner Do?
Specifically, General Partners manage the end to end logistics of a real estate syndication, including the following tasks:
- Drafting the syndication agreement
- Underwriting the deal
- Finding, comparing, and selecting investment opportunities through due diligence and comparative analysis
- Arranging the financing for direct purchase and other expenses
- Building an investment strategy and business plan for each investment opportunity
- Marketing the investment opportunity to potential Limited Partners
- Managing the property directly or overseeing the property management team
- Handling the syndications tax, insurance, and other financial obligations
- Managing the relationships with limited partners
- Managing the sales process when it comes time to sell the property
In return for all of this work, the General Partner is compensated through a combination of fees charged to investors and a share of the profit upon sale.
What Does a Limited Partner Do?
As described above, Limited partners are passive investors. They provide some or all of the capital required to get a deal closed, but have no say in the day to day management of the real estate asset.
If there are any disagreements between the GP and the LP(s), they are governed by the Operating Agreement – which is a document that outlines the GP/LP roles and responsibilities in great detail and must be signed by the LP as a condition of participating in the deal.
Syndication rules require that Limited Partners be “Accredited Investors” who meet certain annual income/net worth requirements. But, vetting potential LPs is generally the GPs responsibility to ensure they have the income and assets required to invest in a deal.
How Does Real Estate Syndication Work?
Now that the key roles are established, let’s illustrate how a real estate syndication works with an hypothetical example.
Suppose that we found a grocery store anchored retail center and, after significant analysis, we have determined that it is a good deal, so we offer to purchase it for $25 million.
Once the offer is accepted, we will quickly work to set up a single purpose entity, an LLC, and use that as the vehicle through which to complete the purchase.
Next, we arrange debt with one of our preferred lenders and they are willing to offer a loan at 80% LTV or $20,000,000 – which means that we need to raise the additional $5 million from Limited Partners.
To do so, we put together a number of key documents such as the syndication agreement, operating agreement, subscription agreement, and offering memorandum and get to work sending them to investors who we think may be interested in our deal. Often this must be done quickly, because once the property is under contract, we have to close within 60-90 days.
Once the needed equity is closed and we have completed all of our due diligence to ensure the property has no major issues, we will get the deal closed and transferred into the name of the LLC.
After closing, we take over management of the asset and handle all aspects of the day to day operations including leasing, maintenance, accounting, reporting, and perhaps most importantly investor distributions – as outlined in the syndication agreement.
What is a Syndication Agreement?
A Syndication Agreement is a legal document that contains specific information about the roles, obligations, and responsibilities of both the Limited Partners and the General Partner.
The specifics of a Syndication Agreement can vary widely from one deal to another, but they typically all cover the same information, including:
- Voting Rights Within The Syndication: This section outlines the voting rights of each part regarding major investment decisions like changes/renovations/repairs to the property.
- Profit Distribution for General and Limited Partners: The syndication agreement also outlines the distribution of profits, disbursement schedules, and other vital details of the financial aspects of the relationship between the general partners and limited partners. This particular section can be complex so it is always a good idea to consult with a CPA or tax attorney to make sure it is understood fully.
- Standards and Practices For Communication Between General and Limited Partners: The syndication agreement sets the standards for how often members of the syndication must meet, for how long, and what must be addressed in each meeting. This establishes the level of trust and transparency limited partners can expect when they invest in a real estate syndication.
Prospective Limited Partners are required to review and sign the Syndication Agreement prior to completing their investment in the syndicated deal.
What Are Acquisition Fees?
General Partners do the bulk of the work in a deal and they do not work for free. They charge fees for their services, some of which are designed to recoup their upfront deal costs while others are passed through to third party vendors.
Acquisition fees typically range from 1% – 5% of the deal size.
What Are Asset Management Fees?
If the members of a real estate syndication vote to manage the property at their own expense instead of hiring a third-party property manager, then the syndicator will charge an asset management fee that often equates to 10% of the gross monthly property income (from rent, parking fees, etc.).
What are Cash Flow and Appreciation?
The basic business plan for a commercial property is very simple. Property owners charge rents to tenants for the privilege of leasing the space. That rental income is used to pay for the property’s operating expenses and debt service and, if there is anything left over, it is distributed to investors (both GPs and LPs). This is typically referred to as cash flow.
Over time, property rents tend to go up, which causes cash flow to increase. When it does, the value of the property appreciates, which may allow it to be sold for a price that is higher than what was paid. These are the two primary sources of return from a real estate syndication.
What Are The Benefits of Real Estate Syndication?
For Accredited Investors, there are many benefits to a commercial real estate syndication. The most important are described below:
Remember, Limited Partners do not have a role in the day to day operations of a property – it is handled by the General Partner. But, by virtue of their real estate investment, they do have a claim to a share of the income and profits produced by the property. So, any income earned is considered to be passive income because they did not have to do anything to earn it.
Suppose that an investor has $150,000 in capital to invest in the commercial real estate asset class. Instead of putting it all into one property, they could spread it across three different syndicated deals, providing their portfolio with an added layer of diversification.
In addition, price movements in real estate tend not to be closely correlated to movements in the bond and stock markets. As a result, this is another level of diversification for investors.
A syndicated investment comes with two very important tax benefits.
First, from an operations standpoint, accounting rules allow property owners to take a certain amount of depreciation each year to account for the physical deterioration in a property’s condition. Since depreciation is a non-cash expense it lowers taxable income, but does not reduce the amount of cash available to real estate investors.
Second, if the investment group manages to sell the property for a profit, they can defer capital gains taxes by reinvesting sales proceeds into a like-kind property using a transaction known as a 1031 Exchange.
For both of these reasons, commercial real estate tends to be a good fit for high income earners who are looking to reduce their tax liability.
What are the Drawbacks of Investing In a Real Estate Syndication?
Although they can come with many important benefits, a real estate syndication investment is not suitable for everyone. Potential drawbacks include:
- Liquidity: A typical syndication has a required holding period of 5-10 years during which time an investor is unable to withdraw their money. Even if they are, they may have to take a significant discount to do so.
- Operational Control: Again, Limited Partners have no operational control over the properties that they invest in. They defer this responsibility to the General Partner, which highlights the need to make sure they have a strong track record of performance.
- Market/Credit Risk: Market risk is the risk that market conditions will become unfavorable for the performance of the investment. For example, interest rates could rise causing a spike in vacancy and collection costs. Credit risk is the risk that a tenant can’t or won’t pay their rent, which can also impact a property’s performance.
- GP Risk: The performance of an investment is highly levered to the skill and knowledge of the General Partner leading it. Thus, it is critically important that they have a good reputation and a history of success.
Each individual investor has their own risk tolerance so it is up to them to evaluate both the risks and the benefits to determine the best real estate investment for themselves.
Who Is Eligible To Invest In Real Estate Syndications?
Depending on how the specific syndication structure is used, the investment eligibility requirements differ.
A 503(b) syndication is available to both accredited and sophisticated investors, while a 506(c) is open to accredited investors only.
The SEC defines an accredited investor as a person with income exceeding $200,000 for two prior years, or over $300,000 joint income with a spouse. Or, the person must exceed $1,000,000 in individual net worth or joint net worth with a spouse without considering their primary residence.
Though no governing body “accredits” investors, companies offering investment opportunities look to the SEC guidelines when determining whether a person is accredited. Ultimately, the discretion lies with the company offering the investment opportunity.
As recently as 2020, the SEC updated the accredited investor guidelines to include individuals who possess certain professional credentials, individuals who are considered knowledgeable employees of a private fund, and registered investment advisors. This change opened the door for people holding professional credentials like doctors, lawyers, and other professionals.
The SEC defines sophisticated investors as individuals or businesses with “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of prospective investments”.
As with accredited investors, there is no certificate a person receives that labels them a sophisticated investor. Instead, it is through SEC guidelines and a private company’s discretion that a person is considered sophisticated.
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 want to learn more about our investment opportunities, sign-up to get access to our deals.