Chapter 1: What is Real Estate Syndication?
Introduction to Group Investment
The first question that should be answered regarding real estate syndication is simply: What is Syndication? Simply stated, syndication is the uniting of multiple parties for investment purposes; syndication is group investment. Typically when investors come together in this manner, each party has a different interest and expectation regarding the syndicate. Some members will take a more active role in the syndicate and be involved with operations and management, while others may simply provide investment capital and take a quieter or more passive role. Real estate syndication is the means for investors with limited personal finances to pool their resources with other investors to acquire properties that are traditionally only available to wealthier investors. This is not to say that wealthy investors cannot pool their resources; it is not uncommon for wealthy investors to syndicate the purchase of very large properties as well.
Over the years the word syndicate has garnered a negative connotation from the public due to the association with organized crime. In some parts of the United States syndication is actually referred to as group investment in efforts to disassociate legal operations with that of the criminal domain. The reason people are so adamant about the reputation or reaction that the word generates is that a syndicate must also be a business--legally formed and documented. Although a syndicate is not legally recognized as a type of business, syndication is not legal or illegal. Syndication is simply the way a multi-party investment business is defined.
All Types of Syndicates
Because syndication is the way investors define their project--and projects can vary greatly--there are also several classic types of syndicates that are traditionally formed. The different types of syndicates are broken down based on the purpose of the investment; investments can range from two people making a joint investment on a single family home, or it can be as complex as having hundreds of investors to build a stadium. Commonly syndicated real estate investments have been used to acquire land, to build housing developments, to remodel or "flip houses, to own shopping centers and strip malls, to build movie theaters, mobile home parks, commercial office buildings, resorts, hotels, stadiums, and just about any other form of real property that one can own.
We will review the different types of entities that a syndicate may form under in chapter 7, but they may take the legal form of a tenancy in common, a joint tenancy, a trust, a general partnership, a corporation, a co-operative corporation, a limited partnership, or a limited liability company. The entity that a syndicate chooses to represent the investment business is based on the investors' rights and liabilities regarding part-ownership of the company. When investors decide to syndicate, the forming of an entity is one of the first decisions that must be made.
Why Syndicates are Formed
A real estate syndicate is formed for the same reasons anyone invests in real estate; these reasons are, but are not limited to: spendable cash, to take advantage of any tax breaks that may apply regarding real estate investments, to gain equity, to protect or hedge against inflation, to profit from a property's appreciation, to secure capital, or simply for high investment returns. To break it down further, investors are all interested in what will happen to the money they put into a real estate investment; and for many, the allure of partial responsibility in an investment and the correlation between larger properties and larger returns is all the encouragement they need to form or join a syndicate.
Chapter 2: The Pros and Cons of Real Estate Syndication
Dollars and Cents
Having stated that syndication exists for the same reasons anyone invests in real property, it is important for anyone involved with a syndicate to understand the different motivations an investor may have to ensure their syndicate's success. If a syndicate member cannot understand the motivations or intentions of their partners, conflict is bound to arise. As previously discussed, there are seven traditional reasons an investor may want to sign onto a piece of real estate:
- Spendable cash refers to the amount of money available after a syndicate's bills are paid (i.e. mortgage, management, etc.) in contrast to the amount of money that was initially invested. In any given real estate investment the average spendable cash returns can range anywhere from one to twenty percent, and are typically higher than most other forms of investment. This, of course, is not considering appreciation; should the value of the property increase during the term of ownership, spendable cash benefits will increase as well. Spendable cash is the biggest motivator for any syndicate investor, as syndicate members are typically not interested in the pride of ownership, the use of the property, or for speculation. When it comes to syndicated real estate, properties that promise high spendable cash returns will always be better received than those that do not.
- Tax advantages that an investor may enjoy regarding real estate are due to the depreciation of a property. In this case, depreciation is not referring to the physical degradation of a property or the economic value in relation to the appraisal; this instance of depreciation is in reference to the State and Federal tax laws regarding real estate. Every year it is assumed that real property will depreciate in value and investors in real property are legally able to report this depreciation as an expense on their taxes. Subsequently this allows the investor to offset any additional sources of income by reporting a real estate loss; often this creates a tax shelter for income that the investor would like to have minimally taxed.
If a property is purchased as non-depreciable it cannot serve as a tax shelter for investors, but it can offset taxation through the interest payments that are recorded as a deduction in tax records. Any payment that may be claimed as a deduction regarding real property is referred to as tax deferral, but is not a tax sheltering method. In these instances the payments that are deducted from an investor's income will defer the taxable income from the current tax year to the next. As stated earlier spendable cash is by far the biggest motivator for investors involved in real estate syndication, but wealthier investors are often very interested in sheltering their income from taxation. If a real estate investment property carries a large mortgage debt that leaves very little spendable cash every month after debt service, a large depreciation may be the best motivator to investors. High profile investors are traditionally more interested in properties with high depreciation in hopes of creating a tax shelter.
- Equity in real property is the actual percentage of monetary value the investor holds of the property in comparison to the amount of debt; essentially equity is how much of the property the investor actually owns. This is an important motivator for some investors, as they are interested in the buildup of equity in an investment. Equity can build through what is referred to as leverage, in which a financed property's debt is much greater than the original amount of investment. A familiar phrase in the world of real estate is positive leverage; this is referring to a type of leveraged property in which the income generated from the real estate property is greater than the interest rate of the loan.
- A classic story that most Americans are familiar with is the one in which a person purchased or could have purchased a property in a prime location for a few thousand dollars several years ago, and now the same piece of property sells for millions. This is the power of appreciation, and if a developing area is potentially a high value market in the coming years it may prove to be the persuading factor to sell an investor on the project. Investors that are persuaded by the speculation of appreciated value in a property are potentially open to receiving a small initial compensation in hopes that they will receive a large compensation during the future sale of the property or of their personal shares.
- A very common misconception amongst potential real estate investors is that as state or national price levels rise, the cost of real estate and labor and materials for a real property will increase as well. The reason this is not entirely true is that most real properties are under a lease in which the owner's monetary return is set for a period of time as declared in the lease. Even though the value of the building which is being leased is rising and the price of renovations, building materials and labor are increasing, fixed rent leases can be used to hedge or protect the property from inflation. A dramatic rise in property value may even prove to be profitable for an investor even when a property was negatively leveraged initially.
Obviously each syndicate that is formed will have different motivators that persuade investors, and in most cases a combination of reasons for syndication may be the reason that an investor chooses to put money into a syndicated project. As stated before, the most important reason for the typical investor is spendable cash. The rest will just prove to persuade or dissuade the investor from participation in the syndicate. As the history of investing goes, a project with high returns and little risk is very rare. So it is ultimately up to the investor to decide if there are too many dissuasive factors to keep them from investing.
Why People Might Shy Away from Real Estate Syndication
In order to understand the motivations of a potential investor, it is also important to know what factors may prove to demotivate or dissuade investors. Naturally, reasons that a person may cite as dissuading factors will vary and may even be personal or non-business related; however, there are four common negative influencers that may cause an investor to shy away from a real estate investment; these dissuaders are marketability, the risk of obsolescence, time and management of property, and various political or environmental risks. Syndication does not increase or decrease these negative persuaders as they are directly related to real estate as an investment regardless of individual or syndicated investment.
- Simply stated, real estate is not as marketable as other investments. With real estate there is a demand, but the market is not as reliable as other industries. If an investor would like to cash out of their investment and sell their property, it can be difficult for the property to sell. Even when working with a real estate broker or agent there really is no guarantee that the property will sell in a timely manner, if it will sell at all. Even when the economic situation has created a "buyer's market", it can still prove to be a challenge when selling property. There are even occasions when a property owner cannot even give real estate away. The fact is, a property cannot be put on the market and be sold the same day unless there is a pre-arranged sale or stroke of luck. Even if there is an immediate buyer for the property, the sale of real estate can be a long process that can take up to months to complete. So even if there is a buyer ready to purchase the property, there will still be a patience-trying length of time between the start and close of sale.
- The risk of obsolescence is the skeptical investor's favorite reason to avoid real estate investments. Obsolescence can happen two different ways in the world of real estate; one being location and the other being technological. An example of a location-related obsolescence would be the operation of a gas station or a roadside motel off of a main thoroughfare; if the road is relocated or traffic is diverted by the creation of a new thoroughfare the motorist-friendly establishments that were once profitable now become inconvenient and virtually useless. To give an example of technology-related obsolescence, a movie theatre was once considered a great investment, but with the introduction of high-quality home-theatre equipment and accessible media the classic movie theatre took a hit. Other examples are record shops or music retailers, at one time they were highly profitable, but as records gave way to compact discs and eventually to mp3s and digital distribution there is really not a practical need for these retailers. In these cases, the property can either evolve to serve a new market, or fall victim to obsolescence.
- The third most commonly cited reason for not investing in real property is personal time and management. This is a problem typical with property intended for rental agreements or leasing, and even more of an inconvenience in smaller properties. The problem is that without excellent tenants, it is up to the investor to act as the management for the property and collect rent and maintain the property. To investors that value their time, this could prove to be an unwanted job. If the investor were to hire a property manager their salary paid for the convenience of outsourcing will come from the overall profitability of the property--and in smaller properties it will often prove to be impractical.
- Changing government policies and economics are also considered dissuading incentives as they are often unpredictable and sometimes financially disastrous to investors involved in real estate; but in the same speculative vein environmental risks are equally as unpredictable and dangerous. The location of real property may render the investment susceptible to flooding, wildfires, earthquakes, tornadoes, hurricanes, and so on. These are unpredictable and sometimes disastrous forces that may or may not be covered by insurance. Insurances that will cover property from such damages will also have to be calculated into the investment, and could lower the overall profitability of the investment.
Every pro or con mentioned in this chapter will effect the success or failure of a real estate investment. Even if negative elements seem to outweigh the positive, o ensure that an investment is successful it will require that investors have a variety of skills to combat or fortify a positive or negative factor. Throughout the years the negative factors and lack of required skill sets have persuaded many people to pursue other forms of investment and shy away from real estate. For this reason the role of a real estate syndicator is very important. Syndicators are meant to acquire the necessary skill sets and provide investors with the security and quell any fear that they may have about investing in a real estate project.
Chapter 3: Anatomy of a Syndicator
What is a Syndicator
When it comes to forming a real estate syndicate, choosing a syndicator to head the project is the first step. A syndicator is essentially the manager, producer, organizer, planner, and legal representation of the syndicate. With so many hats to wear, the syndicator may be an individual or a separate business entity that works to find a project worthy of syndication, find investors that will complement the investment and quell any fears or negative concerns that the investors may hold regarding the investment. It is very common that a syndicator be a real estate broker, an accountant, or a lawyer that works primarily with real estate; it is not required that a syndicator have such credentials, it typically turns out this way as people in these occupations are up to date on new opportunities and are continually approached by people that may be interested in real estate investments. The syndicator is a person that chooses to sell themselves to investors in demonstrating that they have the necessary skills and experience to operate a syndicated investment.
In order for real estate syndication to be successful a project must have a syndicator and investors. It is not a requirement that the syndicator must acquire all of the investors or sell the investors on a project, but in order for a syndicator to more successfully lead the operation it is a good idea for them to seek out and secure investors for the project. The best practice in successfully syndicating a project is for the syndicator to identify and temporarily hold a property meant for syndication, have architectural schematics or drawings prepared for a project that needs to be constructed or renovated, a solid breakdown of costs mapped out, pre-arranged financing for the project, and a complete plan drawn out for the use of real property ready to present to investors before forming a syndicate.
Investors have one main responsibility in a syndicated project, and that is to provide a solid financial backing for the syndicator as he or she acquires the property; and since investors are only financially involved in a project they must be completely convinced that the project will be profitable. The syndicator must be organized and present a clear plan in order to secure funding from investors. To do so, the syndicator must absolutely know where the returns on the investment will come from, an accurate estimate of returns, and a clearly identified attorney or accountant that will aid the syndicator in the financial operations of the project. Once the syndicator can answer the financial questions that a potential investor will have, he or she typically will meet with syndicate candidates to review the proposal and solicit their involvement in the syndicated project.
Issuers vs. Dealers
Syndicators can be broken down into two categories based on their skill sets: issuers and dealers. If the syndicator is a real estate lawyer or more familiar with the legal and contractual requirements in syndicated properties they could be considered an issuer. An issuer primarily handles legal formation of the entity, acquisition of properties, and the completion of and organization of legal documentation regarding the investment. If a syndicator is a real estate broker or agent that has extensive experience marketing a selling real estate, they may be identified as a dealer. A dealer's knowledge and experience is mainly applied in the marketing and selling of syndicate shares or interests. A syndicate can operate successfully using a syndicator that only has one of these skill sets, and some syndicators may be well-rounded and prove to be capable in both aspects of syndication.
Because the syndicator has so many duties and responsibilities regarding the investment project, it is commonplace to delegate or relinquish some of the duties to other syndicate members or employees that prove capable. For example if a syndicator is an issuer that has no interest in managing the project, after inception they may hire a manager to handle the operation of the syndicate in their place. This practice is not uncommon as several syndicators hire property managers to handle the real estate while the financial management remains in their hands. To become a syndicator, one should familiarize themselves with the duties and responsibilities of a syndicator throughout the entire syndication process and carefully decide which jobs to take on and which to delegate.
Broker by Day/Syndicator by Night
The most common profession of a syndicator is a real estate broker. This is probably because real estate brokers are constantly approached with real estate listings and carry the experience and knowledge necessary to see a potentially sound investment opportunity. The real estate broker carries a bit of an advantage when approaching a syndicated real estate project; if a broker picks up a listing for a piece of property that he or she feels may do well as a syndicated project, they can simply solicit the project to investors and virtually build a buyer for the property. In this case, since the broker would have the property listing the commission from the sale of the property would go to the syndicator that happens to have brokered the entire deal. Since the broker typically has first access to listings, they can act quickly when they find a desirable project and even potentially negotiate with the seller for an exclusive listing on the property meaning no other broker will have authority to sell the property during a set period of time.
Although the real estate broker appears to have an advantage in acting as a syndicator and obtaining immediate cash benefits from the act of syndication, there are several more-than-capable occupational backgrounds that syndicators may come from: they may be an entrepreneur that is familiar with real estate investment, a former or current property manager, an accountant, an attorney, they could be an insurance broker, an asset manager, a financial planner, or a building contractor. All of these potential syndicators carry their own obvious and not-so-obvious advantages when acting as a syndicator. Because a syndicator is responsible for the formation of the syndicate, the management of the property, and the operations of the entire project, it only makes sense that acting as a syndicator will hold financial compensation for the expected effort.
Paying the Syndicator
A syndicator is typically also an investor in the syndicated project, and any investor has two viable options when it comes to real estate investment: they may either purchase a property on their own, hold the property, operate the property, and eventually attempt to resell the property for a profit; or they may use their own funds to act as a down payment in attempts to own a portion of a larger property with the assumption that a larger investment leads to larger returns. For example, imagine that you are a syndicator currently holding $50,000 to invest in a project:
With that $50,000 you may purchase a $250,000 property for twenty percent down owning the entire property and all cash benefits yourself. If the spendable income on this project is ten percent, you hold it for five years, and then resell it for a $50,000 profit you will have received $25000 in spendable income finalizing the investment as a ten percent spendable income return with one-hundred percent profit at time of sale totaling $75,000 in profit for a sole ownership after five years.
Alternatively, you may take your $50,000 investment through syndication and purchase a $2,500,000 property for $500,000 using 9 other investors that all apply their own $50,000. The same as above will apply for this example; the property is held for five years, generates ten percent spendable income, and is sold for a $500,000 profit. Because you are the syndicator for this project your immediate cash returns are partially from compensation for the job that you are responsible for. With that said, assume that you hold a 25-percent interest in the syndicate for spendable income returns and resale. With this sort of leverage, you will personally receive $62,500 profit in spendable income. Combined with the even distribution of the 100-percent profit your initial $50,000 investment will return $112,500, with the rest of the investors returning roughly $70,800 individually.
Clearly the benefit of syndication is illustrated, and more specifically the benefit of being a syndicator is illustrated. The example above is a hypothetical investment from which the syndicator profits through an agreement with the syndicate that 25-percent of spendable income generated will go to the syndicator as compensation, which means 25-percent of all syndicate profits will go to the syndicator as stated in the profit formula for this fictitious syndicate. Depending on a syndicator's experience, reputation, personality, knowledge, success, and the risk involved with the project, the syndicate will agree or contend the profit formula that is arranged by the syndicator. It is simple ethics that a person must be compensated for the work that they do, and investors should already know this. So if an investor is not happy with the terms of compensation that the syndicator will apply, they should probably not invest in the project since the profit formula is in place to regulate the profit legally and offer fair compensation for the amount of work and responsibility that is required of the syndicator; an investor that is unhappy with the implementation of a profit formula will be unhappy with the investment from the beginning to the end.
A profit formula is the percentage of profit from spendable income and/or proceeds from the sale of shares in the syndicate that will go toward paying the syndicator. With a profit formula it is common that the syndicator must prioritize the payment schedule which results in payment of the investors before the syndicator can take any profits. Payment to the investors is usually a cumulative amount of the annual projected revenue of the investment. States will regulate the priority of cumulative payments to investors in a public syndication differently; for example, in California an annual cumulative return of at least five percent is required to be paid to investors before the syndicator can accept any payment from spendable cash or profits from syndicate shares that may be sold. In private syndicates it is not uncommon for the investors to require the full amount of their investment as a return before the syndicator may collect payment from syndicate profits.
Having briefly discussed public and private syndication, it is important for a syndicator to know how the shares of the syndication will be traded before the formation of the business entity as this will also affect the profitability of the syndicate which in turn affects the syndicator's profit. There are advantages and disadvantages of having a public or private company represent the syndication, and the governmental regulation of a public or private company is considerably different. A public syndicate is able to raise money from the sale of its shares or interests. These shares are available for anyone to purchase in the open market, or they may be issued to employees of the syndicate. A public syndicate's shares have a regulated "fair market value which is determined by the amount of which a share was sold through a particular stock exchange. Private syndicates cannot sell their shares on the open market; they may distribute shares to employees, but it would prove difficult to sell these shares as their value is generally speculative. Public syndicates are required to spend more on accountants and legal representatives that will fulfill the State and Federal requirements of a publicly traded company in reporting syndicate affairs to the public. For example, in the United States a public syndicate is required to report all profits and compensation for the owners as public knowledge in accordance with the Sarbanes-Oxley Act; this does not apply to private syndicates in which the financial information of the company is relatively unknown by the public.
The syndicator's compensation in regards to a public versus a privately held syndicate is greatly affected by the decision to be public or not. Privately held syndicates usually consist of a small group of close-knit investors that will agree on a contractually enforced amount of financial compensation. In private syndicates the investors will often grant the syndicator a very liberal financial compensation of somewhere between twenty and fifty percent of the profits after a determined amount is repaid to the investors. In public syndication a large compensation does not make much sense to regulatory agents, so state securities and exchange commissions will typically allow the syndicator what they deem to be fair compensation rather than negotiating with the investors; the percentage of profits that the syndicator may receive in public syndication are usually ten percent to thirty percent of the profits post investor repayment. Because of the lower standard for profit-based compensation in public syndication the syndicator must rely more on the sale or trade of syndicate shares for profit, or on front-end commissions before the government agencies are involved.
Although the commissioned sales benefits associated with the syndicator also being a real estate broker are attractive, there are other areas for front-end profit for other syndicator's that do not have the occupational background of a broker: First, a syndicator may have the opportunity to sell the property to the syndicate. If the syndicator owns a piece of property that will be syndicated, they may sell it to the syndicate for a profit; however, legally the amount of profit that will be earned by the syndicator in the sale must be disclosed to the syndicate. Second, the syndicator may receive commission on the sale of property or syndicate interests; commissions garnered from the sale of shares or company interests are called securities commissions. Another area for syndicator profit is in building fees; if the syndicator is a builder or contractor on a project where construction is required they may receive compensation for their services as a building contractor. Finally, for a syndicator that is good with drafting contracts they may add a clause to the syndication agreement that will allow the borrowing of money from the syndicate; in doing so the syndicator has access to a tax-free cash flow with an interest rate that is determined by the syndicate in the agreement. At a pre-determined date the funds the syndicator borrows from the syndicate must be returned with interest, but during this time, said funds may be used to invest in other projects or purchase shares from the syndicate resulting in a larger return.
The Risk of Being a Syndicator
Naturally, in relation to the financial advantages there are disadvantages to acting as a syndicator for a project. The first responsibility that the syndicator has is to put forth the deposit money and take the risk of losing the deposit if the sale does not close; and because the syndicator is responsible for the deposit, if the syndicate comes up short it is the syndicator's responsibility to protect the deposit by providing the necessary financial means to meet the required balance. Because the syndicator is responsible for the investment, they must usually be financially able to cover at least sixty percent of the investment in purchasing the other investors' shares if needs be. As investors choose to leave the syndicate, depending on the agreement, the syndicator becomes responsible for their investment shares and must purchase them to cover the negative balance. If a syndicator builds a positive reputation the financial responsibility may be reduced, but in order to be a professional syndicator it is a good idea to have the financial means to cover the investment.