9245 Poplar Ave. Ste 5 #105 Germantown, TN 38138
Real estate investing has become increasingly famous as a significant way of diversifying our sources of income. Luckily, you can venture into this business as a passive or an active investor, depending on your daily engagements.
However, before kicking off, you need to consider your personal goal: How much time and capital you’re willing to spend and the returns you expect to receive. If you can entrust your funds to someone who runs and controls the business on your behalf, then real estate syndication is a good idea.
So, what defines real estate syndication? How does it work? And how do you benefit from this type of real estate investing?
In this article, we’ll answer these questions comprehensively to help you make an informed investment decision. Let’s get started.
What Is Real Estate Syndication?
Real estate syndication is a type of passive real estate investing where you pool your capital contribution together to invest collectively. It comprises general partners or sponsors and limited partners, also known as passive investors.
The sponsors actively participate in daily functions and the business plan implementation. On the other hand, passive investors’ involvement is restricted to capital contribution, and they’ve insignificant investment control.
However, you’re still entitled to tax benefits, returns, and ownership.
This type of passive investing is suitable for trusts, family offices, individuals, and any investor who wishes to combine effort with others to acquire a large property.
Moreover, syndication allows you to invest in multiple properties without expertise. You rely on the professionalism and research of active investors.
The Real Estate Syndication Structures And Mechanics
There are two common real estate syndication structures, including:
- Straight split
- Waterfall
A straight split structure offers higher potential returns to passive investors and risks of the same magnitude. On the other hand, a waterfall structure has more conservative splits to the investors than to the sponsors.
The structural differences in real estate syndication result from factors such as:
- General partners’ personal preferences, experience, and track record
- Current position in the market cycle
- Investment market
- Particular property
So, besides the sponsors, asset class, and market, you must assess the structure of your potential real estate syndication. Ensure it’ll meet your investment goals.
For that reason, we look at how the straight split and waterfall structures work to help you determine the ideal one for you.
Straight Split Real Estate Syndication Structure
The straight split syndication structure is straightforward, using a predetermined sharing percentage across the board. It utilizes a percentage split between the sponsors and the investors.
The set ratio applies to sharing all asset proceeds, including cash flows and capital gains generated from the asset sale. The splits you are likely to find are 80/20 and 70/30. It means that the passive investors would get 80% and 70%, while the sponsors receive 20% and 30% of the returns in the first and the second splits, respectively.
For example, if you agree on the 70/30 split, 70% of the proceed is distributed among the passive investors, while 30% goes to the unlimited partners. So, if you earn a profit of $300,000, you get $210,000 as investors, while $90,000 is divided among the sponsors.
The split is constant whether you earn little or much funds.
You may come across other splits, including 40/60, 30/70, 20/80, and 10/90. And, of course, the bigger percentage belongs to the investors while the other one goes to the sponsors.
The straight split syndication deal is ideal for passive investors, whose returns are bountiful.
Waterfall Real Estate Syndication
This real estate syndication structure uses a preferred return (pref). Unlike the straight split structure, the waterfall structure works with various percentages when sharing returns. Once the proceeds reach the target percentage, it ‘spills’ to the next.
For example, for an 8% preferred return syndication, the first 8% of the proceeds go to the investors. The sponsors will only get what exceeds the 8%.
So, if you invest $150,000 in a syndication real estate business with an 8% Pref, your first year’s returns are 8% of your investment, which is $12,000. In this case, the sponsors receive no returns.
Although you may not get the full 8% all the time, your position as a passive investor enables you to get preferred consideration for the first 8% returns. Additionally, this structure motivates the general partners to work harder to generate returns past the 8% threshold.
And After The Preferred Return?
After attaining the 8% threshold, you apply the subsequent few percentage splits.
For example, you may have an 80/20 split for returns between 8% and 16%. In this case, 80% goes to the passive investors, while the sponsors receive 20% of the proceeds. Upon reaching the 16% stretch, the split may change to 50/50.
The 100- 80/20- 50/50 sequential splits give this structure the name ‘Waterfall.’ Investing under such a syndication structure is safe as both parties are bound to gain.
First, it aligns with the investors’ interests as the sponsors will only go for the properties whose returns are more than the Pref. Secondly, this structure incentivizes the general partners to work harder on your behalf to meet the target threshold. The higher the returns, the more money the sponsors receive.
Which One Is The Better Option?
Both syndication structures are great investment strategies. Your choice depends on how well it can meet your investment goals. Therefore you must consider the risk factor, the property’s likelihood to appreciate, the capability of the general partners, and the holding duration, among other factors.
In most cases, passive investors prefer the waterfall structure due to its guaranteed returns through the ‘Preferred Return’ system of profit sharing. It allows you to earn a more stable annual passive income.
However, this real estate syndication structure takes a low-risk investment strategy. Consequently, it yields more conventional returns depending on the specific property.
Real Estate Syndication Profits
The real estate syndication business returns come from rental income and asset appreciation.
The rental income is then shared among the investors monthly or quarterly as per the business’s predetermined terms. Since the asset appreciates years down the line, the rental income increases, and once the property is sold, it fetches significant profits. As a result, investors can earn more over time.
The returns payment of a real estate syndication business depends on the maturity time of the particular investment. While some syndication matures within 6 to 12 months, others will mature within 7 to 10 years. Every investor receives profit at the end of the specified duration.
However, the general partners usually take an upfront profit (acquisition fee) at the start of the deal to facilitate the research and the purchase of the property. It’s usually 1% of the capital contribution on average but can range between 0.5% and 2%.
In the case of a waterfall real estate structure, all investors must receive a ‘Preferred Return’ before the general partners receive any profit. The preferred return is usually 5-10% of the initial capital annually.
What Should You Consider When Evaluating A Real Estate Syndication?
As an investor, consider the following key areas when evaluating a real estate syndication:
- Appropriate synchronization: The program may have strategies to ensure that the investment runs smoothly until the end. Assess if the objectives align with your financial goals and if they’ll enhance the achievement of your goals in the future.
- Action plan: The syndication should have a plan of action on how things will run throughout the project’s lifecycle. Most importantly, the plan should align with your investment goals. Also, ask for clarification on any unclear detail about the project.
- Track record: Search for reliable information about the syndication’s past performance. Real estate management requires experience to achieve the desired results. And a successful track record promises excellent results.
- Relation with investors: Find out your potential syndication’s relation with investors. Conduct effective background investigations by studying rumors and interviewing competitors.
- Holding duration: You must know how long the syndication holds their property as most of them prefer a 5-7 years holding span. Although the duration yields good returns, are you satisfied with the extended timeframe?
- Financial sources: Evaluate the source of funds of your potential syndication and get sufficient information about the loans they may have taken. That includes the interest rate and repayment duration, among other details.
- The downsides: Enquire about the syndication’s past failures, their cause, if they managed to correct them, and how they ‘bounced back.’
- Management skills: Assess the syndication’s portfolio to know its asset management capability, success, and profit distribution to investors.
Parting Shot
Syndication is an excellent form of passive real estate investing. It allows you to earn extra cash without taking an active role in investment. And your involvement and liability are limited to your capital contribution.
This investment generates reliable funds from rental income and asset appreciation.
However, when selecting potential real estate syndication and the specific structure, you must be careful. Always consider the investment’s terms and ensure that they align with your investment goals.
Also, do thorough research about the syndication’s expertise, past performance, and risks. Since you’re a hands-off investor, working with a team you know and trust is brilliant!