You've Heard of Syndication, but what does it mean?
Multifamily real estate syndication is where you pool resources from many investors to purchase a multifamily asset larger than any individual investor could have done on their own.
This is a form of passive real estate investing where skilled professionals manage the asset on behalf of a united group of investors.
The united group of investors is called a syndicate. You could form a syndicate for any large business related transaction, up to and including purchasing companies themselves.
While technically a syndication could be formed for a deal of any size, the purpose of forming a syndicate is for large transactions that individuals would be unable to purchase without investor partners.
The Rise of Syndication
In recent years, real estate syndicates have become an increasingly popular way for investors to passively benefit from investments in the real estate market.
One of the most popular forms of real estate syndication is for the purchase of multifamily apartment buildings.
In this article we will give an overview and review of the structure and components of multifamily syndication:
Syndication involves the selling of securities to your investors, which makes it an activity regulated by the Securities and Exchange Commission in the United States.
In order to comply with SEC regulations, you must file a Form D notice and designate your offering as one of the following:
In these offerings, you may only accept accredited investors, but you may advertise your offerings. You must verify that these investors are accredited. There are third party services that can verify this status for you.
These offerings may not be advertised, however you can accept up to 35 sophisticated investors in addition to your accredited investors. The accredited investors do not need to be verified.
Additionally, you will need to work with your securities attorney to draft a private placement memorandum for the offering.
This document will give a legal overview of your offering, including information regarding: legal disclosures, who the general partners for the offering are, a complete property description, the investment term or duration, rules for allocations and distributions, investment terms, risk disclosures, fees, and storage of funds.
Please read our Private Placement Memorandum (PPM) Operating Agreement, and Rule 506 For Real Estate Syndication Explained article for more information on this topic.
Any syndication will composed of two main groups, the general partners (GP) and the limited partners (LP).
Limited partners (LP):
The limited partners are the “passive” investors in the deal.
They have limited liability and are not involved in asset management.
After committing to the deal, signing the private placement memorandum and associated documents, and wiring their investment, their work is more or less done.
They will then receive distributions over the course of the hold period from cash flows according to the structure for each deal.
When the property is sold or refinanced, they’ll receive their initial capital back in addition to the money they receive from their portion of the profit share.
LPs receive an annual schedule K1 with their money received in cash flows, as well as any depreciation they received, which helps offset the tax liabilities from cash flows.
The limited partner group will be made up of accredited investors and may also include sophisticated investors.
Many people are confused about these terms.
Accredited investors are any individuals who meet either a net worth requirement of $1 million (not including their primary residence) OR they have an annual income of $200,000 for a single individual or $300,000 for a married couple.
If you meet these criteria, you are automatically labeled as an accredited investor.
The term “accredited” sometimes trips people up and makes them think they need to be registered or certified by some board, but that’s not the case.
A sophisticated investor is a non-accredited investor that is capable of weighing the risks involved with investments because they possess a sufficient amount of financial knowledge.
This is obviously a loose definition, but the purpose is to protect those with little or no experience from getting in over their heads.
If you are raising money from sophisticated investors, be sure to confirm they have some experience with investing and would qualify as sophisticated.
General partners (GP):
These are the people who put the deal together.
They find the deals, find the debt financing for the deal, and raise equity capital from their investors.
They are the ones who acquire and sign on the debt and put the deposit money up front to obtain the asset.
They then manage the asset over the course of the hold period.
Key principal (KP):
This is an optional designation that is not always used. If a member of the GP group is particularly important in securing the debt, they may be designated as a key principal.
These may be individuals that have a higher net worth and meet lender liquidity requirements.
Fees and Compensation:
As we discussed earlier, the limited partners are passive investors who typically receive distributions from cash flows as well as from the sale or refinance.
This can be structured in a variety of ways and you can even have different classes of limited partners in a single deal.
For example, we could have a deal where we offer two classes of LP shares.
One class might have a higher preferred return, but no share of any profits in the event of a sale, whereas the other class has a lower preferred return, but their upside is they get to share in the profits after the sale at year seven.
You can probably envision how different investors with different priorities and methodologies for evaluating risk might be attracted to one option over the other.
It’s really up to you to find a way to structure an attractive return for your investors that fits within your deal.
For the general partner, their compensation is typically a combination of their portion of the promote structure as well as the fees they receive for putting the syndication together.
The term “promote” in this sense refers to the share of the profits that go to the GP.
The structure can be put together in any way the general partners want, but there are a few ways this is typically done.
The first is a simple percentage split. For example, you could say that 60% of all cash flow are distributed to the limited partners, with the remaining 40% being distributed to the general partners. This ratio then carries and continues to apply at the time of a sale or refinance.
The second option is to use a waterfall structure. An example of this would be that 70% of all cash flows go to the limited partners with 30% going to the general partner UNTIL you reach some specified return threshold.
For this example, we’ll say that once we reach a 10% IRR, any profits above that threshold would be split with 50% to the limited partners and 50% to the general partners.
These thresholds are referred to as “hurdles.” As you jump over them, you’re now in a new stretch of the race with new conditions.
Fees Involved with Syndication:
- Upfront Acquisition Fee: This typically ranges from 2-4%, depending on size of the deal. The smaller the deal, the higher the fee.
- Asset Management Fee: Once the property is purchased and the hold period has begun, this is paid for asset management. The general partner team is making sure the asset is being protected and the business plan is operating as envisioned. It usually ranges from 2-3%, paid out on a monthly basis.
- Construction Management Fee: If substantial renovations are required, either the operator or property management company may charge this fee, which is typically 5% of the construction budget.
- Capital Event Fee: This is paid if the property is refinanced and ranges from 1-2%.
- Disposition or Exit Fee: This fee is paid out when you sell the asset and is based on the sales price. This typically ranges from 1-2%.
- Loan Guarantee Fee: This is a fee for guaranteeing the loan and ranges anywhere from 1-3%.
10 Step Syndication Process:
- Cultivating Investors:
You need to continually build a list of people who may potentially be interested in investing with you.
While you might not have a specific offering yet, you can’t put the cart before the horse. If you don’t have some reason to believe there are people interested in investing with you, then you’ll have a hard time submitting offers for deals, won’t you?
- Finding Deals:
You will need to identify your target markets and then pound the pavement networking with brokers and property owners. Your deal pipeline needs to be full at all times.
- Underwriting Deals:
You’ll need a system for analyzing the deals sent to you.
You need to be aware of the risks involved, how this deal might perform in the current debt environment you’re operating in, and model projected returns.
- Submitting Offers:
After underwriting a deal that looks attractive, you’ll submit an LOI. If it’s an off-market deal, you might need to do some additional convincing or have additional discussions to firm up the property owner’s commitment to sell. If the deal was sent to you by a broker, then you may be competing with other parties with your offer.
- Investor Capital:
Using your cultivated list, you find investors that are interested in this specific offering and receive their soft commitments.
You need to secure debt that corresponds with your business plan. Debt structuring is extremely important and often overlooked.
- Due Diligence:
This is perhaps the most crucial component of the process prior to the sale. Proper due diligence includes both on-site inspections and financial record analysis.
- Asset Management:
Once the property is under your ownership, you need to ensure that all the time and money you and your investors have put in is secure and that your business plan is being implemented.
Working together with the property manager, you implement systems for daily operation as well as turnover or renovation plans to increase rent growth and stay within budget.
- Investor Relations:
During the hold period, the general partners need to keep their investors informed about the investment’s performance, interface on any questions, and maintain the relationship, as you are partners together on the investment.
- Sale or Refinance:
Depending on the business plan, either a sale or refinance will be the final step of your asset management plan. Remember to conservatively project what your exit value will be.
You should budget for a cap rate increase of 1 basis point per year during your hold period to be safe.
Tips for Syndication:
- Partners are extremely important. Different partners should play different roles that play to their individual strengths. While all partners should be well rounded and involved on some level with every element of the business, dividing responsible in a logical way will make your team far more efficient.
- You should have some of the heavy lifting done before you submit an LOI on a deal. Ideally, you should have the bulk of your PPM already drafted due to the tight timeframes involved here (you’ll usually only have a month or two to secure your investor capital from the signing of your purchase and sale contract). Additionally, investor relationships can take time to develop. You shouldn’t be putting big deals under contract without a robust investor list.
- When dealing with investors, remember that everything you put out is reflecting on your company. Investors want to see order and systems beyond just your functional need for them. This demonstrates how conscientious and responsible you are and will be with their investment. Properly functioning systems and attention to detail are critical.
- You should only take on investors that understand your business plan and that you are comfortable with. Both sides should be comfortable with relationship, as, depending on the structure of the syndication, you’ll be working with this person for 5-10 years.
- Investors want to see how you are as a communicator. They will be working together with you on this investment for years to come and will rely on you for updates. Monthly updates, articles, blog posts, and other content of this nature can help your investors feel more comfortable with you and your company.
- You need to make it very clear how to invest with you and the process for securing their spot in your investment offerings via a soft reserve.
- Real estate syndication is a team sport. Make strategic partnerships with people who have skills you don’t have. You need to leverage the strengths of multiple people in a complementary way to get the best results.
- Network with other people in the syndication space, forge strategic partnerships, and learn and provide value to others. This will pay dividends in the long run as you find new partners, mentors, colleagues, and friends that can provide you with priceless lived experience.