Investing in real estate can be a powerful way to build wealth, but it’s crucial to vet any syndication offer thoroughly before committing your hard-earned money. Real estate syndications allow investors to pool their resources with other investors to acquire properties or portfolios that would be challenging to purchase individually.
In this comprehensive guide, we will break down the process of evaluating a real estate syndication offer and understanding its structure. Whether you are a seasoned investor or just getting started, these insights will help you make informed decisions.
Understanding Your Investment Goals
Before diving into the specifics of any syndication deal, you must clarify your own investment goals. This foundational step ensures that any potential investment aligns with your broader financial objectives.
Ask yourself:
- Do you prefer capital preservation, or are you seeking aggressive growth?
- Is your priority cash flow, equity appreciation, or tax benefits?
- What is your investment timeline? Are you in the accumulation phase, transition phase, or looking for cash flow?
- Do you fundamentally believe in real estate as an asset class that can help you achieve your long-term investment goals?
Clarifying these points will help you identify suitable deals and avoid those that don’t align with your goals.
Consider an investor in their early 30s, earning a stable income from a high-paying job. This person might prioritize aggressive growth over immediate cash flow, aiming to maximize equity appreciation over the next decade. The ideal syndication offer here would focus on value-add or development projects in high-growth markets, providing significant upside potential.
Conversely, consider an investor in their late 50s who is five years away from retirement. This individual might prioritize capital preservation and stable monthly or quarterly cash flow to help smooth the drawdown of assets in their overall portfolio so that their money lasts for their entire retirement. This investor’s ideal syndication offer would focus on debt instruments or fully stabilized projects that are focused on cash flow.
Screening the Deal
Once an investor fully understands their goals, risk, and timeline and has started receiving deal flow from a fully vetted operator, the next step is to understand how to evaluate the offer presented, as well as its structure.
Screen the market
Since real estate is immovable, a syndication’s success heavily depends on the market in which the property is located. To screen a market and location effectively, consider these criteria:
- Population Growth: Look for markets with increasing population trends. An expanding population typically drives demand for housing and can lead to higher occupancy rates and rental income.
- Job Growth and Diversity: Strong job growth and a diverse economic base indicate a healthy economy. Markets dependent on a single industry are riskier.
- Income Growth: Increasing household incomes can lead to higher rental rates and improved property values.
- Crime and Poverty Rates: Declining crime and poverty rates often correlate with higher property values and a more stable tenant base.
- Landlord-Friendly Legislation: States with laws favorable to landlords can mean simplified property management and eviction processes.
- Tax Environment: Consider state, local, and property taxes, as they can significantly impact your net returns.
Investor Tip: Always do a property search on the actual location to ensure it is actually in the metro advertised. For example, an operator might market a property in Austin, Texas, but with a quick internet search, you might find that the property is actually 45 minutes outside Austin, in a submarket with different fundamentals.
If the deal you are looking at is largely a commercial business—-like self-storage or express car washes—-you will also want to ensure the deal is in a location with great traffic patterns and low competition.
For example, imagine you’re considering a syndication offer in Austin, Texas. You’d start by analyzing the area’s population growth, which has been robust due to a strong tech industry. You’d also note the city’s job diversity, with significant contributions from the tech, education, and healthcare sectors. These positive trends, combined with relatively low crime rates and landlord-friendly regulations, make Austin a promising market for real estate investment.
Most investors are investing in a syndicated deal so they can leverage an expert’s knowledge and expertise of the investment strategy, market knowledge, and team. However, an investor should always do their own market due diligence—“trust but verify.”
Gathering reliable market data is crucial. Utilize reputable sources such as CoStar, Marcus & Millichap, CBRE, and public market reports. Websites like City-data.com and Niche.com provide valuable insights into demographic and economic trends.
Screen the deal
Once you’ve identified that the market is promising, it’s time to screen the deal itself. Here’s a quick framework to help you decide if a deal is worth your time for a deeper investigation:
- Operator Vetting: Ensure the deal is managed by a trustworthy operator with a strong track record. Ideally, you have already vetted this operator.
- Asset Class: Make sure you understand the asset class (e.g., multifamily, self-storage, car washes) and its performance metrics.
- Goal Alignment: Verify that the deal matches your investment goals and timeline. Don’t invest in a development deal when you really need cash flow.
- Risk Tolerance: Assess if the deal aligns with your risk tolerance and “sleep well at night” criteria.
- Red Flags: Be wary of any red flags, such as unrealistic projections or opaque business plans.
Having a quick five-to-10-minute screening process can help you get to a fast “no” or “maybe” on a project.
For example, consider a deal for an express car wash in Greenville, South Carolina. You check the operator’s background and find they have successfully managed multiple similar projects. The asset class is familiar to you, and the projections appear conservative.
You then ensure the deal aligns with your goals of steady cash flow, moderate equity growth, and stellar tax benefits. Finding no immediate red flags, you decide to dive deeper into the vetting process.
Vet the syndication offer and structure
Vetting a deal goes beyond the initial screening and requires a thorough examination of several critical areas of the deal structure. Just like building muscle, developing your deal-vetting skills takes practice and repetition, but over time, it will become second nature.
When vetting a deal, focus on how the operator is safeguarding these six pillars of wealth.
1. Capital preservation
To assess whether your investment will protect your money, look at a few important things.
First, check market stats like how many people live there, how many jobs are there, and if people are making more money over time. Make sure the area is strong and growing.
Next, see if the laws and taxes are favorable to real estate investing. Look at other properties like yours that have been sold recently to see if they’re selling for the same price. Make sure the deal has enough money set aside for regular costs and big fixes, ideally enough for six to 12 months. Lastly, make sure there’s a clear plan to sell or get out of the deal if things change.
For example, if you’re thinking about investing in an apartment building in Raleigh, North Carolina, you’d check that the city is growing, with lots of new people moving in and plenty of jobs. You’d also make sure that other apartments like the one you’re looking at have sold for about the same price. And you’d want to see that the deal has enough money set aside for a whole year of operational costs and has a good plan for what to do if things don’t go as planned.
Doing this careful review will help you feel good about whether your investment will keep your money safe.
2. Cash flow
To gauge how much money a deal might make, focus on a few important things.
First, make sure the predictions for how much money the property will bring in and how much it will cost to run are conservative. Check that the expected rate of empty apartments is reasonable and covers both physical problems and people who can’t pay rent. For instance, a building might be 95% full, but if only 80% of the people are paying rent, that’s a problem.
Look at the expected yearly cash return, which shows how much money you might get each year compared to how much money you put in. Also, check how many people need to live in the building for it to make enough money to cover its costs (break-even occupancy), since this changes depending on the kind of building.
Consider an offer to invest in a commercial apartment building in Savannah, Georgia, where the plans say rent will go up by 2% each year, which is consistent with recent rent bump-ups in the area. The syndication thinks 5% of the apartments will be empty, which is like how things were before. They say you might get an 8% yearly cash return and need 70% of the apartments to be occupied to break even. This deal seems like it could make good money each year.
3. Equity growth
To evaluate the potential for growth in your investment, it’s important to look at a few key factors. Start by reviewing the operator’s plan to see how they aim to boost net operating income (NOI) by increasing revenue and cutting costs.
It’s also crucial to verify that recent property sales support the expected future value of the property. Understand the projected returns, including the internal rate of return (IRR), which calculates the rate at which future cash flows match the current investment value. The annualized rate of return (ARR) gives the average yearly return over the investment period. Another metric to consider is the equity multiple (EM), which shows the total cash distributions relative to the initial investment.
Based on my interactions with investors, a common question that arises is: “Which asset class offers the best returns?” The answer depends on personal goals, risk tolerance, investment horizon, and portfolio objectives. Therefore, it’s crucial to familiarize yourself with these financial metrics to assess whether an investment aligns with your specific needs.
For instance, consider a syndication offering a multifamily property in Charlotte, North Carolina. It projects a 4% cash-on-cash return in the first year, increasing to 7% by the third year, with an IRR of 14% and an ARR of 13%. Over seven years, the equity multiple is expected to be 1.8x.
These metrics suggest a well-rounded investment opportunity, balancing both ongoing cash flow and potential for equity growth.
4. Smart leverage and financing
Using leverage wisely can boost your investment returns, but it also comes with increased risk, as recent market events have demonstrated. When evaluating how a property is financed, consider a few key factors.
First, determine if the loan is recourse or non-recourse, as this affects your personal liability. A lower loan-to-value (LTV) ratio, typically between 60% to 75%, generally indicates less risk because it means you’re borrowing less compared to the property’s value. It’s also wise to prefer fixed interest rates or adjustable rates with rate caps to ensure stability in your payments over time.
Interest-only (IO) periods can be beneficial initially, as they enhance cash flow by allowing you to pay only the interest on the loan for a set period. For instance, a recent syndication offer for an industrial property in Chicago includes a non-recourse loan with a 70% LTV ratio. The loan has a fixed interest rate of 4% for five years, with an initial three-year, interest-only period designed to increase early cash flow. This conservative financing approach matches well with the property’s stable income profile, balancing leverage to manage risk effectively.
5. Tax benefits
Many investors find real estate appealing because of its great tax benefits.
One major perk is depreciation, which lets you deduct from your income each year without spending actual money. Another strategy, called cost segregation, speeds up this depreciation, giving you big tax savings, especially in the first few years of owning a property. Bonus depreciation adds to these benefits by allowing you to deduct a high percentage of the property’s cost upfront in the first year.
On top of that, there’s the 1031 exchange, where you can delay paying taxes on your gains by reinvesting in similar properties. For instance, if you invest in a group buying a Seattle apartment building, using cost segregation could mean getting early tax breaks. Plus, planning for a 1031 exchange when you sell could maximize how much you save on taxes.
For further tax information, be sure to consult a professional tax advisor.
6. Evaluating the operator
Even if you’ve already checked out the operator, it’s a good idea to do a quick follow-up to make sure nothing significant has changed with their business since your last conversation. Here are a few things to look into.
First, run background checks to see if there are any legal or financial issues in the operator’s history. You can also do a simple Google search using terms like “legal” and “lawsuit” to see if there have been any recent developments.
Next, if you haven’t already, talk to other investors who are currently working with the operator on a deal. Their experiences can give you a better sense of what it’s like to work with them.
Take a look at the operator’s track record by reviewing how well their past deals have performed compared to initial projections. This will help you gauge their reliability and success rate.
Last, ensure the operator is open and responsive to your questions. Transparency is key when you’re entrusting your invested capital to someone.
For example, if you’re considering investing in a syndication managed by an operator with 15 years of experience in multifamily properties, you might find during your checks that there are no legal issues, and references from other investors speak highly of their transparency and clear communication. Their past deals consistently meeting or surpassing expectations would further strengthen your confidence in their ability to manage your investment effectively.
Key Components of a Syndication Offer
Real estate syndications provide various investment opportunities by combining borrowing (debt) and ownership (equity), each influencing different levels of risk and potential rewards. When investors understand these components well, they can thoroughly evaluate syndications, considering their structure, the risks involved, and the potential returns they might generate.
Let’s explore each component:
Investment structure (debt, equity, identified asset, funds)
Debt involves borrowing money that needs to be repaid with interest, while equity means owning a share of the property and participating in its profits and losses. Syndications can target specific properties or pool funds to invest in a range of properties.
The “capital stack” represents the different layers of financing involved, such as senior debt, which is the safest and repaid first; mezzanine debt, which has moderate risk; preferred equity, which offers higher returns than debt but is paid before common equity; and common equity, which carries the highest risk and potential returns and is paid last. When a limited partner invests in an equity deal, they are most likely investing in the common equity class and get paid back before the general partner does.
For example, in a syndication to purchase a $10 million apartment complex, the capital stack might include $6 million in senior debt, $2 million in mezzanine debt, $1 million in preferred equity, and $1 million in common equity. Legal entities like LLCs are commonly used to manage these investments and facilitate tax-deferred exchanges under Section 1031. This provision allows investors to defer capital gains taxes by reinvesting in similar properties, making it easier to grow their real estate portfolios without immediate tax implications.
Understanding these components helps investors evaluate the structure, risks, and potential returns of real estate syndications.
Underwriting and projections
When evaluating a passive real estate investment opportunity, understanding the underwriting process and financial projections is crucial for making informed decisions.
Let’s consider a syndication offering investment in an apartment complex. Begin by comparing the rent rates of similar properties in the area (rent comparables, or comps) to gauge realistic income expectations. Reviewing the property’s past operating statements provides insights into its financial performance, detailing income streams and expenses.
Understanding the debt structure is pivotal. Imagine that the syndication plans to finance the acquisition with a $5 million loan at a 4% interest rate with a 70% loan-to-value ratio. Knowing whether the loan is recourse (where the borrower is personally liable) or non-recourse (where only the property secures the loan) is crucial for assessing risk.
Additionally, evaluating exit assumptions is necessary. Suppose the syndication assumes a sale in five years based on projected market conditions and a specific capitalization rate (cap rate). Analyzing these assumptions helps investors anticipate potential returns and risks associated with the investment.
By methodically assessing these factors—rent comparables, operating statements, debt structure, and exit assumptions—investors can better understand the syndication’s financial health and potential profitability. This approach empowers investors to make sound decisions based on a thorough understanding of the investment’s projected returns and associated risks.
Sources and uses of funds
Assessing the “use of funds” involves examining how the sponsor plans to deploy the raised capital. This could include $7 million for property acquisition, $2 million for renovations, and $1 million for reserves.
It’s crucial to scrutinize the sponsor’s financial assumptions to ensure they are realistic and conservative. These assumptions, such as projected rental income and expense forecasts, influence the syndication’s expected performance and affect the potential returns for investors.
By comprehending these elements—the capital stack, use of funds, and sponsor’s financial assumptions—investors can better grasp the syndication’s risk-return profile. This understanding empowers investors to make well-informed decisions about participating in passive real estate investments, providing clarity on the anticipated allocation, distribution, and potential outcomes of their invested funds.
Waterfalls and profit splits
In real estate syndications, profit distribution often follows a structured framework known as a waterfall. This mechanism outlines how profits are divided between investors and sponsors, based on predetermined criteria.
Typically, investors receive preferred returns—fixed percentages of profits—before any further distributions occur. The waterfall structure then delineates how additional profits are split at various return levels.
Initially, these splits often favor investors more until specific return thresholds, known as hurdle rates, are met. After these benchmarks, the sponsor typically receives a larger share of profits.
For example, in a syndication with a straight split waterfall, profits might be divided 70% to investors and 30% to the sponsor until a certain profit threshold is achieved. Beyond that point, the split ratio could shift to 50% to investors and 50% to the sponsor. This contrasts with the capital stack, which primarily concerns the order of debt repayment and equity positions rather than profit distribution percentages.
Understanding these distinctions is crucial for investors evaluating potential returns and risk profiles in real estate syndications.
Fees
Understanding the fees associated with a real estate syndication is crucial for investors, as they can significantly affect overall investment returns. These fees include acquisition fees for purchasing the property, ongoing asset management fees, day-to-day property management fees, and disposition fees when the property is sold.
It’s essential for investors to ensure all these fees are clearly disclosed in the syndication’s offering documents. This transparency allows investors to evaluate the total cost of investing and understand how fees may impact their net returns.
Investors typically prefer offerings that show a net return after deducting all fees. This approach avoids the need for investors to perform complex calculations, or “mental gymnastics,” to determine their actual returns.
For example, if a syndication promises an 8% annual return, investors would expect this to be the return they receive after accounting for all fees associated with the investment. By focusing on net returns, investors can make more informed decisions about where to allocate their capital and understand the true profitability of the investment opportunity.
Legal entities
For passive real estate investors, understanding legal entities like LLCs and 1031 exchanges can significantly impact investment strategies.
Limited liability companies (LLCs) are commonly used in real estate syndications because they offer liability protection for investors and potential tax benefits. By structuring investments through an LLC, investors can shield personal assets from potential lawsuits related to the property and potentially benefit from pass-through taxation, where profits and losses flow through to individual tax returns.
Final Thoughts
Real estate syndications offer chances to earn passive income and grow wealth. But to make sure you’re making smart investments that match your financial goals, you need to do thorough research and careful planning. This includes checking market trends, understanding how deals are structured, reviewing financial forecasts, and assessing fees.
Investing in real estate always comes with risks, so it’s wise to talk to financial advisors, lawyers, and tax experts before making any decisions. By following these steps and seeking professional advice, you can confidently evaluate syndication opportunities and make choices that fit your investment strategy.
Remember, being well prepared and making informed decisions are crucial factors for success in real estate investing. Here’s to your success in building wealth through real estate syndications!