What Can Passive Investors Expect from a Real Estate Syndication?
Taking your first steps into real estate investing is an exciting time for an investor. Yet, it can also be challenging to catch up on the terms and determine how to analyze your options.
In multifamily real estate syndication, passive investors contribute a portion of the funds needed to purchase and operate the building. In return, investors’ equity in the building earns them money from collected rents, refinance of the building, and proceeds when the building is sold. Thus, as the building earns more money and increases in value, so too do the investors make more money from their initial investment.
Read on to better understand passive investors’ role in syndications and learn how to get started with your first deal.
What Is Real Estate Syndication?
Real estate syndications allow investors to reap the benefits of investing in multifamily housing for a small fraction of the project’s overall capital needs. The project sponsor does the heavy lifting regarding making the project happen.
A syndication is a form of crowdfunding for real estate. The passive investors, also called limited partners (LPs), fund all or part of the project. In return, the LPs receive equity in the building that translates to payouts from the project’s revenue and appreciated value, as determined by the syndication agreement.
The Syndication Sponsor Finds, Drives, and Manages the Project
The syndication’s sponsor finds the project, secures financing, conducts the purchase transaction, and then does the legwork to ensure the project makes money. Therefore, much of the success or failure of the project depends on the sponsor’s knowledge, skill, and effort.
What Happens During a Syndication Project
The project itself is an income-producing multifamily building. The tenants who live there pay rent, providing a steady source of revenue to the project. For the first two years of the project, we update each unit as its former lease expires.
By renovating units, we will increase rental income. We also reduce costs through efficient management, utility savings, and the reduction of other expenses.
Not only does this increase the net operating income, meaning more profit for everyone, but it also increases the building’s market value. This is because income-producing properties are valued based on their income potential rather than comparable sales like residential property.
For example, if the net operating income increases by $10,000 for a building with a 5 percent capitalization rate, the building’s value skyrockets $200,000 ($10,000 ÷ .5 = $200,000). This type of increase is crucial for maximum profits when selling the building.
Syndications continue until the project terminates, which usually happens when the property is sold. Most syndications last no longer than seven years, but the sponsor will outline the length of the project in the syndication agreement.
How Do Passive Investors Make Money
Passive investors provide the project’s financing. In return for supplying a portion of the funding, the investors may recoup their capital through revenue distributions and shares in the building’s equity.
Syndication returns can be structured in various ways, but one that is most friendly to passive investors centers on preferred returns.
Under preferred return plans, limited partners are the first to receive a portion of the revenue. For example, in my upcoming project, investors receive initial payments within 45 days of the end of each quarter until they earn 7 percent of their initial investment back. This means that the limited partners are the first ones to see money coming in.
Oftentimes, the building can be refinanced after the renovations are completed at the end of the first 2-3 years. At that time, the limited partners receive 100 percent of their capital returned, per the proforma. When the project reaches an internal rate of return (IRR) of 15 percent, the LPs and sponsor will continue to split the revenue 50/50 until the LPs receive 100 percent of their capital back.
From there, the investors and sponsor continue to split profits as determined in the operating agreement. This means that investors continue to earn income from the project, even after they get all their money back. At this point, investors are earning mailbox money, meaning all they have to do is cash the checks.
How to Join a Real Estate Syndication
When investing in a real estate syndication, wise passive investors know that joining the syndication is anything but passive. This is the part of the process where investors should research their sponsor and vet the project before signing on.
Non-accredited investors can search online for syndication projects through platforms like Fundrise and Realty Mogul, but it can be challenging to find open projects, and each syndication sets its minimum investment amount.
My projects have a $100,000 minimum investment and are open to both accredited and non-accredited investors. Learn more about investing with Cameron’s Commercial Real Estate.
After finding a project and sponsor that seems like the right fit, expect several documents that define the terms of the project and clarify how the LPs will be paid.
Before committing to a project, the sponsor should provide a private placement memorandum or investment overview. The overview acts as a written introduction to the project, explaining the purpose and potential value of the investment. For example, it will include the current rental occupancy and rent amounts of a multifamily building.
The subscription agreement serves as an application to join a syndication as a limited partner. The document specifies the number of shares that the LP is purchasing and at what price.
Finally, the operating agreement clarifies the payment schedule throughout the lifetime of the deal. This document describes the percentages of the preferred return for investors, the profit split after reaching the preferred return, and whether the limited partners are entitled to any funds when the property is sold.
The operating agreement also clarifies what happens in the event the project requires a capital call, which is when investors provide additional capital. Capital calls are often planned, especially for projects with renovations, to allow investors to hold onto their money until it is needed by the project.
The sponsor’s real estate attorney drafts the operating agreement, and you may choose to have your own attorney review it.
After finalizing the paperwork, it is time to fund the project. Limited partners wire the money about one week before closing. Just like when purchasing a residential property, the money is usually sent to the title company for closing, but the sponsor will provide specific details.
This step marks the downhill point for limited partners. From here, the sponsor acts as the boots on the ground and takes care of the project from this point forward.
Enjoy the Passive Part of Investing
Throughout the life of the project, limited partners receive quarterly revenue distributions as well as updates from the sponsor regarding the property’s performance. LPs do not have to deal with the many property management issues that will arise; that is the sponsor’s responsibility.
Real estate remains a tried and true investment vehicle, and in part, this is because of the tax advantages that are unique to real estate. These advantages help investors keep more of the money that they earned in their pockets.
As a limited partner in a real estate syndication, you get to enjoy these same advantages. First, know that real estate income gets taxed at a lower effective tax rate than earned income. Whereas earned income, like from a traditional paycheck, can only be reduced by spending money, passive income from real estate is reduced by amortization and depreciation.
The many deductions for real estate rental income shelters much of the earnings, creating a lower effective tax rate. Real estate normally depreciates over 27.5 years, but syndication sponsors can use the accelerated depreciation method to claim 27.5 years’ worth of depreciation over just five years.
As such, limited partners receive a Schedule K-1 tax document each year. It reports your share of the income, deductions, and credits. Investors can expect a 7-to-8 percent depreciation coupon, which ends up making the preferred returns tax-free.
Additionally, when investors receive their capital back via building refinance after renovations, that money is also tax-free.
All investments carry risk, including multifamily syndications. Choosing a syndication with a sponsor with a proven track record and experience in the industry is one step you can take to lower your risk.