Breaking Down Real Estate Syndication and Why It's So Powerful
What is Real Estate Syndication?
Real estate syndication is nothing more than the pooling of resources to acquire a piece of real estate. It's a partnership where a real estate syndicator (sponsor or general partner) procures and structures a deal, and investors (limited partners) pledge capital towards that investment.
Despite a more informationally efficient marketplace, the real estate industry remains rigid and illiquid. Considerable time and expertise are required to source, cultivate, buy, and manage investment real estate. And most investors don’t have the time nor the expertise to complete a transaction themselves - and are more content taking a passive investing role anyway.
The marriage of the investment team's complementary skills, education, and resources creates a synergy where the pooled resources are greater than the sum of its parts. It gives a sponsor access to more substantial capital pools for higher quality and larger investments. It allows investors the benefit of real estate ownership without the day-to-day hassles of managing a property.
How Syndication Works
Let’s start with a vignette.
A real estate syndicator or sponsor identifies a 50-unit apartment complex that can be acquired. The property offers robust in place cash flow. Still, there is some vacancy – and through the sponsor's experience, they've identified that they can add property value with some property renovations and improvements.
The sponsor doesn’t have the capital to fund the acquisition themselves. But through the course of their business, they've developed a network of like-minded investors interested in real estate investments. So, the sponsor forms a syndication, raises the requisite capital, and acquires the property.
Typically, a private placement memorandum is drafted, and a new LLC is formed for each investment. The limited partners are given ownership shares in the entity, while the deal sponsor executes the business plan and manages the property.
At the end of the predetermined hold period, or based on other disposition criteria, the sponsor will sell the asset. Each capital contributor’s initial investment is paid out in total, and additional proceeds are split amongst the partners.
The Benefits of Syndication
Perhaps the most significant benefit of a real estate syndication is the increased access to quality investments through pooled capital and increased deal flow. Many investors don't have the expertise to evaluate or acquire investment real estate. And if they do have the experience, most don’t have time to source and underwrite hundreds of deals looking for the “one.” Instead, a sponsor will shoulder this burden – relying on their network, outbound and inbound lead generation, and their experience in due-diligence. And when a deal is uncovered, a single investor won’t need to put up all of the capital for acquisition because the sponsor is crowdfunding equity from various other limited partners.
Syndication is a unique type of commercial real estate transaction that also adds a layer of diversification to an investor’s portfolio. Instead of acquiring a single property, an investor can make smaller capital contributions in several deals, thus reducing their exposure to any lone piece of real estate.
Another advantage of syndication is the aligned interest between the deal sponsor and limited partners. Many syndicators invest their own capital in a deal, which signals their financial “buy-in.” And because sponsors are given equity in the property as opposed to collecting a management fee, they are also liable for the success or failure of a project. This helps to reduce any principal/agent disconnect and friction.
Finally, real estate syndication gives investors the benefit of being a direct owner in real estate without the burden of having to manage a property actively. This means each investor has limited liability against 3rd parties (tenants and contractors). There won’t be any 3 a.m. phone calls about clogged toilets or management decisions about what deferred maintenance to prioritize, etc. Syndication provides the benefit of predictable cash flow with professional property management.
Why Real Estate vs. Another Investment?
Most importantly, real estate offers multiple profit centers. It provides predictable monthly cash flow from rental payments while also delivering capital gains through a property’s appreciation in value. And as a tenant’s rent covers debt service and pays down the mortgage, each owner builds equity in the property.
Real estate also benefits from the ability to use financial leverage – creating a situation of nearly risk-free arbitrage using a lender’s capital. For example, let’s compare a $25,000 investment in stocks vs. a $25,000 investment in real estate as a down payment for a $100,000 property. If both assets appreciate by 10%, the stocks gain $2,500, while the real estate earns $10,000. The use of leverage enables an investor to experience significantly greater appreciation on the same cash invested.
We shouldn't ignore the various tax incentives afforded by real estate investment either. Interest payments and depreciation, which is a non-cash expense, serve as tax shields. At the same time, cost segregation and accelerated depreciation can be used to offset gains even more. Not to mention, a 1031 exchange transaction allows for the deferment of capital gains and the opportunity to roll proceeds over into a more profitable piece of real estate. And often overlooked is the fact that real estate can be refinanced without triggering a taxable event – allowing an investor to pull equity from a property to fund other investments.
Investment in real estate finally offers several intangible benefits that other assets don’t. First, it provides diversification – real estate is not highly correlated with other asset classes and delivers risk reduction benefits to an investment portfolio. Real estate also acts as a natural hedge against inflation through annual rent escalators and value appreciation. But most importantly, it's an investment backed by a physical asset. In a world of speculative bubbles and virtual currencies, an investment that has intrinsic value and can be updated and repaired has a unique appeal.