Real estate syndications offer investors a way to pool funds in pursuit of deals, opening opportunities not available to individuals. But, acting as the key principal in a syndication deal – while requiring more involvement – also has some significant benefits. As such, we’ll use this article to explain the role of the key principal in a real estate syndication and why you might want to be one.
Specifically, we’ll cover the following topics:
- Real Estate Syndication Overview
- Pros and Cons to Being a Real Estate Syndication Principal
- Final Thoughts
Real Estate Syndication Overview
In 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. Syndications allow investors and real estate professionals to pool their capital and experience to make a deal happen.
The Role of the Syndication Principal
With the syndication model, a deal principal (also known as a sponsor or syndicator), finds, underwrites, and executes a commercial real estate deal. As part of that underwriting process, the principal 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 principal pitches the deal to potential investors. In a commonly-used syndication model, the investors receive a minimum required return – paid out prior to the principal receiving a return on his equity investment. If the deal’s performance exceeds this minimum return, the principal 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 principal.
How to Become a Syndication Principal
Gain Experience. Prior to acting as the principal of a syndication, individuals need to build significant deal and market experience. For instance, if a particular deal involves a value-add approach to an apartment building, the principal should have experience analyzing these deals, overseeing general contractors, and driving increased rents. Additionally, principals should have significant experience in the target market. Each area has different supply/demand/pricing factors, demographics, and municipal zoning requirements. A successful syndication typically involves a principal with a wealth of experience in the deal market.
Assemble a Syndication Team. No principal has the skills, experience, and bandwidth to complete a deal on his own. Instead, syndications rely on successful teams. Depending on the deal, the principal will need to assemble, at a minimum, the design team, general contractor, property manager, lender, real estate attorney, and asset management accountant.
Build Capital. Syndications generally rely on passive investors to provide the bulk of a deal’s required capital. However, deal principals still need to have enough capital to conduct thorough due diligence (e.g. environmental assessments, title searches, ALTA surveys, initial design plans, etc.). In larger deals, these items can total tens of thousands of dollars (or more). Additionally, most syndications have a maximum investor equity contribution of 90%, meaning that the principal needs to come up with the remaining 10% equity.
Pros and Cons to Being a Real Estate Syndication Principal
Having outlined the role of the syndication principal, we’ll now discuss the pros and cons of assuming that position in a deal.
Pro 1: Additional Fees
In a limited partnership model, the principal actively participates in the syndication deal as the general partner (GP), while the investors passively participate as limited partners (LPs). As the GP of a deal, this active role goes hand in hand with additional fees. Depending on the deal structure, many principals will charge a development fee, asset management fee, refinance fee, and asset disposition, or sale, fee. Conversely, the LPs only collect distributions from the property’s cash flows.
Pro 2: Control
A principal’s active role also translates to more control over the deal. In most syndications, LPs have little to no say over the planning and execution of a deal. Principals, on the other hand, work with the syndication team to plan and carry out all aspects of a project, from design to permitting to stabilized operations and, ultimately, disposition. If you have a strong vision for a project, this level of control is a major benefit to acting as a deal principal.
Pro 3: Potential for Significant Upside
If a property performs well, a deal principal can generate returns disproportionate to actual equity in the deal. As outlined in the above cash distribution model, once a deal clears the return of capital, investor minimum required return, and catch-up hurdles, the principal begins to receive his promoted interest, or “promotes.”
Con 1: No Minimum Required Return
However, the flip side to the above reality is that the principal does not receive a minimum required return. While every deal is different, most include an LP minimum required return hurdle immediately after the return of capital one. Consequently, if total cash distributions don’t clear this, the principal will not collect a return on investment.
Con 2: Time Commitment and Active Involvement
While some people see the deal control principals possess as a benefit, others see this time commitment and active involvement as a disadvantage. If you’re simply looking to passively invest, serving as a deal principal doesn’t make sense. Yes, these individuals rely on syndication teams, but a principal still holds ultimate responsibility for the success or failure of a deal.
Con 3: Reputation Risk
Related to this ultimate control, deal principals face major reputation risk when they organize syndications. If a deal falls apart, you’ll be hard pressed to convince LPs to invest in future deals. To modify a famous saying, it takes years to build a strong reputation as a syndication principal, but you can destroy a reputation with a single poorly executed deal.
Serving as the key principal in a real estate syndication offers a variety of benefits. However, it also entails more risk while requiring far more active involvement than a passive investor. Bottom line, individuals considering the syndication principal role should closely weigh the pros and cons before committing to a deal.
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.