When Jake & I began our investing career, we only knew of one way to buy real estate. Buy it by yourself! We had never heard of syndication, and to be fair, over ten years ago, the economy and the real estate market were a bit different. Those were the days of 1% GDP growth, low rents, a difficult environment to raise capital for investments, and deals that languished on LoopNet for months and months. Oh, do I miss those days.
Seriously though, the strategy of syndication received a huge jolt from the JOBS Act (Jumpstart Our Business Startup Act) of 2012. The intention of this act was to allow funding of businesses in the U.S. by easing some of the security’s regulations. This is the impact of the JOBS Act from Investopedia:
It lowers reporting and disclosure requirements for companies with less than $1 billion in revenue and allows the advertising of securities offerings. It also allows greater access to crowdfunding and greatly expands the number of companies that can offer stock without going through SEC registration.
You can see the effect it has had on syndication, and multifamily in general. An explosion has taken place over the past decade, which has allowed the average investor to partake in the gains in multifamily.
Before we go any further, let me define to you what a syndication is. Let me turn to Investopedia again, as they have the most succinct and accurate definition:
A syndicate is a temporary alliance of businesses that joins together to manage a large transaction, which would be difficult, or impossible, to effect individually. Syndication makes it easy for companies to pool their resources and share risks.
In effect, you are pooling your money and your investor’s money to be able to invest in bigger deals than they could afford on their own. It is a fantastic way for an investor with limited capital to invest in larger deals.
Watch the video version: “What is A Syndication”
You can also look to the Howey test on the legal definition of what is a syndication in the eyes of the SEC (Securities and Exchange Commission). The Howey Test refers to a U.S. Supreme Court case to determine if the transaction qualifies as an investment contract, and if it does, then it is considered a security and subject to the rules of the Securities Act of 1934. In this case, the Howey Company sold tracts of citrus grove to investors, who leased the land bank to the company. Howey was in charge of the groves, taking the role of what we consider the sponsor. The company did not register with the SEC, and the court ruled that this transaction qualified as an investment contract. More importantly, the Supreme Court created criteria to determine what is an investment contract:
- An investment of money
- In a common enterprise
- With the expectation of a profit
- To be derived from others
(Thanks again Investopedia)
If you are partnering with others, taking their capital, and performing all the work while the partners are passive, be careful. It appears that you are creating a syndication and need to register with the SEC. The only way to be sure is to schedule a call with an attorney who specializes in securities law. At Jake & Gino, we use the services of Kim Lisa Taylor. Always seek the guidance of licensed professionals when dealing with law and taxes.
Who are the parties involved in a syndication? A syndication consists of a sponsor and investors (limited partners). The sponsor is the party that has the experience, puts together the deal, manages the deal, and signs on the debt. They typically put up between 10-20% of the equity. It may seem a bit unfair that they put up so little capital and receive a sizable portion of the equity, but remember. They are the ones who are managing the deal, and assuming most of the risk. The syndication is generally set up as an LLC and the limited partner owns an interest in the LLC.
The sponsor typically gets paid an acquisition fee, a percent based on the total price of the deal (typically between 1-3% of the deal). For example, if the deal is purchased for $5,000,000, and the syndicator charges a 3% fee, then the acquisition fee would total $150,000. Not a bad pay day!! In another article, I will dive deeper into other ways sponsors get paid.
The investors are referred to as limited partners, and their risk is limited to the investment they make in the deal. They are normally passive, meaning that they invest in the deal and rely on the sponsor for managing the deal.
Some of you may be saying the limited partner is not getting compensated enough. I want to introduce a term to you that has changed my paradigm on this statement. I always thought the fees and structure always favored the sponsor. Not anymore!
ROE= Return on Effort
I agree that the syndicator gets compensated generously, but there is a ton of value to an investor who doesn’t have the time or expertise or capital to invest in their own deals. The limited partner has very little effort in this deal once it’s funded, and can focus his efforts elsewhere, while receiving mailbox money.
Three other terms that are extremely important that I would like to touch on are the preferred return, internal rate of return, and the sponsor promote.
With a preferred return, the limited partner is entitled to a certain return, before the sponsor begins to receive compensation. This preferred return is also referred to as a return hurdle. Preferred returns have been averaging between 6-10% the past few years. What this means is that the limited partner receives all of the preferred return before profits are split with the sponsor. For example, if the preferred return is 8%, and the deal produced a 9% return for the quarter, the limited partner receives 8 of the 9% of the profit, and then the remaining profit is split up as per the agreement that was signed amongst the two parties.
Once the preferred return is met, profits start to get split between the limited partners and the sponsors. The piece that goes to the sponsors is called the sponsor promote. The sponsor promote is based on a couple of factors, including the experience of the sponsor, their track record, and what the market is bearing.
Our deals have been structured as a 70/30 split, 70% of the profits going to the limited partners and the remaining 30% going to the sponsor. For example, if our “pref” rate was 8%, then the limited partners would receive the 8%, and the remaining 4% would be split 70/30 between the limited partners and the sponsor.
Many deals are created with what is called a waterfall structure, where the sponsor receives a larger return based on the performance of the asset. As the IRR (we’re about to get to IRR) increases, the sponsor’s returns increase. You may be saying “Why complicate things?” This is an excellent way for the limited partners to incentivize the sponsor to perform on the deal. Win-win for both sides! The limited partners get paid more, but so do the sponsors.
Internal Rate of Return (IRR):
IRR, simply put, is the annual rate of growth an investment is expected to generate, and combines profit and time into one formula. The key is that it takes into effect the time value of money. We could write an article dedicated solely to IRR, and would barely scratch the surface. It is what the vast majority of limited partners will ask when pondering whether to invest in your deal or not. Internal Rates of Return in the low 20% were common back a few years ago, but as cap rates have continued to compress (go down) and pricing has accelerated, most sponsors are now targeting around a 12-15% IRR.
In the next article, we are going to dive into the pros and cons of syndication. We are also going to focus on your goals as an investor and if syndication is the appropriate strategy for what you are trying to accomplish.
It is important to understand that syndication is only one of many strategies when investing in multifamily, and the more “tools” (strategies) you have in your toolbox, the more likely it is that you will find a way to close your next deal.
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