Real estate syndications offer a way to invest in a deal larger than you could make happen on your own. By pooling funds, syndications allow multiple investors to work together in pursuit of a single project. But, like all deals, syndications have risks. Before joining one, savvy investors conduct thorough due diligence, ensuring that the deal is a good one. As such, we’ll use this article to explain how to evaluate a real estate syndication.
Specifically, we’ll cover the following topics:
- What is a Real Estate Syndication?
- Evaluating a Real Estate Syndication
- Final Thoughts
What is a Real Estate Syndication?
With commercial real estate, developers and investors often find great deals but lack the capital to execute. Conversely, many passive investors want a return on their investment but lack the time or expertise to find and lead a real estate deal.
Real estate syndication solves both problems. With the syndication model, a deal syndicator (also known as a sponsor), finds, underwrites, and executes a commercial real estate deal. As part of that underwriting process, the syndicator identifies the cash gap, that is, the difference between the cash required and the cash he plans on personally contributing.
With this cash gap and the deal’s projected returns identified, the sponsor pitches the deal to potential investors. In a commonly-used syndication model, the investors receive a minimum required return – paid out prior to the syndicator receiving a return on his equity investment. If the deal’s performance exceeds this minimum return, the syndicator receives a disproportionate amount of that upside through his catch-up return and promoted interest distributions. This set-up A) protects the investors, and B) incentivizes the syndicator.
In the next section, we’ll outline three steps investors should take when evaluating a potential real estate syndication.
Evaluating a Real Estate Syndication
Step 1: Define Your Investment Objectives
Before investing in any deal, you should first define your investment objectives. Generally speaking, this entails asking yourself several questions. No “right” answers exist to these questions, but asking them will help you decide whether or not investing in a syndication makes sense within your broader financial plan:
Do you prioritize long-term growth? If so, investing in a real estate syndication with a longer time horizon may make sense. Real estate investments are typically illiquid, meaning you cannot quickly convert equity in a deal into cash. But, if you’re looking to grow your wealth over an extended period, that lack of liquidity may not be an issue.
Do you prioritize cash flow? If viewing a syndication as a fixed-income-type investment, you’ll want to closely analyze its projected cash flows. That is, will the cash-on-cash returns provide sufficient and reliable enough distributions to justify tying up your cash for an extended period?
Do you prioritize generating taxable losses? The majority of syndication investors receive passive income and loss from these deals. And, due to the cashless expense nature of depreciation, a well-analyzed syndication will provide positive cash flow while creating taxable losses. If you have other passive income that you want to offset with syndication losses, these deals can be beneficial.
Do you need access to your capital in the near future? As stated above, real estate investments generally lack liquidity. If you have capital you want to commit to a syndication, you’ll first want to ask whether or not you need that cash in the near future. If so, you should either not invest or only evaluate syndications with shorter time horizons.
Step 2: Evaluate the Syndicator
After defining your own objectives, you’ll want to evaluate the syndicator personally. This individual will make or break a deal, so evaluating syndicators plays a major role in due diligence.
- Deal Experience: Does the syndicator have experience in similar types of deals? If a particular deal involves a value-add approach to an apartment building, does the syndicator have experience analyzing these deals, overseeing general contractors, and driving increased rents? Lacking experience, there’s a good chance a syndicator will poorly perform.
- Market Experience: In addition to deal type experience, a syndicator should have experience in the target market. Each area has different supply/demand/pricing factors, demographics, and municipal zoning requirements. A successful syndication typically involves a syndicator with a wealth of experience in the deal market.
- Syndication Team: No syndicator can manage a commercial real estate deal on his own. Instead, syndications are built on the foundation of a successful team. While not an exhaustive list, any deal should have experienced professionals filling these roles: property manager, asset manager, general contractor, leasing specialist, real estate attorney, and accountant.
- Character: Lastly, the importance of a syndicator’s character cannot be overstated. In a deal, you entrust these individuals with a ton of money – can they be trusted? Criminal backgrounds, bankruptcies, and prior failed deals should all be major red flags.
Step 3: Evaluate the Deal
Next, you’ll want to analyze the deal itself:
- Underwriting Technical Accuracy: Underwriting templates typically use spreadsheets designed to translate inputs (e.g. rents, expenses, repair costs, etc.) into outputs (e.g. valuations, cash flows, ROI, etc.). Unfortunately, a minor technical mistake in one of these models can drastically throw off the results, potentially making a no-go deal look like a home run. Rather than solely reviewing an offering memorandum’s executive summary, investors should closely examine the associated template to ensure it functions as advertised.
- Assumption Validity: Once you’ve confirmed the technical accuracy of a deal’s underwriting, you’ll want to closely evaluate the underlying assumptions. Are the projected rents and operating expenses reasonable for the property type and location? Do assumed interest rates reflect current market conditions? During this analysis, it’s better to take a conservative approach than make aggressive – and potentially unrealistic – assumptions.
- Cash Waterfall and Projected Investor Returns: Will the deal be profitable? If so, how profitable? By reviewing the cash waterfall, you will learn how the deal prioritizes distributed cash. Extended over the life of the deal, these cash flows dictate a syndication’s projected returns, normally measured by internal rate of return, or IRR. Investors should measure a deal’s timeline, risks, and returns against alternative investments. Do the deal’s returns justify the associated risks and timeline your cash will be invested?
- Tax Consequences: LLCs, the standard legal form for most syndications, provide significant flexibility. In particular, an LLC operating agreement can include special allocations of taxable income and loss, meaning a deal may be structured so that members don’t necessarily receive income and loss in proportion to their equity percentages. Prior to committing to a deal, you’ll want a clear understanding of its tax consequences and, in particular, whether any special allocations exist.
- Operating Agreement and Investor Protections: An operating agreement is the legal document dictating how a deal will work. Accordingly, you should review these documents closely with your own attorney to ensure that they provide you, as the investor, certain protections. Is your minimum required return clearly listed in priority above the syndicator’s returns? What happens in the event of a deal collapse, that is, how do liquidation distributions flow to deal members? Bottom line, this document should provide significant protections to investors.
The above article provides a baseline for evaluating a real estate syndication. But, even with this information, new investors should work with experienced professionals when analyzing a potential deal. Partnering with an established commercial real estate broker like High Peaks Capital will ensure syndications 1) are thoroughly vetted, and 2) support your personal investment objectives.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.