What Does "Syndication" Mean in Real Estate?
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How Does Real Estate Syndication Work?
There are two roles in property syndication: sponsors (or syndicators) and investors.
The sponsor has an active role, which involves scouting properties, putting together deals, raising capital, and managing the everyday operations of the project or property.
Investors are silent partners; their only job is to provide capital in exchange for returns.
It is not uncommon for the sponsor to also contribute capital to the deal, although in some syndication agreements, the sponsor’s contribution is strictly their operational expertise.
Real estate syndicates are typically special-purpose entities; limited liability companies (LLCs) and limited partnerships (LPs) are the most common structures. The operating agreement or partnership agreement should spell out the rights and responsibilities of each member.
Specifically, the agreement should address:
- Distribution of positive cash flow.
- Voting rights for each member.
- Management fees and other compensation paid to the sponsor.
- Communication requirements.
Regardless of the structure, the entity—not the sponsor—actually purchases and owns the real estate.
How Are Profits Handled in a Real Estate Syndication?
There is no “standard” formula for syndication deals; the syndication agreement can account for the level of risk involved, the sponsor’s track record, the property type, and the time commitment.
The straight split and the waterfall split are two of the most common methods of handling profits in a syndication deal.
This is the simplest way to share profits in a syndication agreement. As the name suggests, all profits are shared proportionally across all stakeholders. Profits can include everything from cash flow and the sale of the property.
If the agreement specifies an 80/20 split, then the passive investors, as a group, share 80% of the returns and the sponsor keeps 20%.
The waterfall split uses a preferred return structure, which means the silent partners get all the profits until a certain rate of return. The sponsor only receives a share of returns above the preferred rate.
This is where the waterfall comes in. Returns over the preferred rate are split between the sponsor and the passive investors that progressively favor the sponsor.
|Rate of Return||Investor Share||Sponsor Share|
|8.1 – 10%||70%||30%|
|10.1% and beyond||50%||50%|
In many cases, the waterfall split is a win-win for all partners because it aligns everyone’s interests. When a sponsor offers a preferred rate, they are confident that the property will earn returns above the preferred rate. For investors, this is as close as they can get to guaranteed returns.
On the other hand, the sponsor has a motivation to outperform the pro forma because they do not get paid unless the property achieves its benchmark. They also keep a progressively larger piece of the profits as the property performs well.
Note that the sponsor may still make money even if the property does not return its preferred rate. Most sponsors get money upfront in the form of an acquisition fee or commission, typically between 0.5% and 2% of the value of the deal. Beyond that, they may also collect fees for managing the property.
Which Split Is Better?
It is impossible to make sweeping generalizations about distribution structures. For a property that consistently earns solid returns, the waterfall split favors investors.
Imagine a $100,000 investment that returns 10% a year or $10,000. With an 80/20 straight split, investors earn $8,000 a year (80% of $10,000).
That same investment under the waterfall split above would return $9,400 to investors each year (100% of the first 8% of returns or $8,000, plus 70% of the remaining $2,000 or $1,400).
On the other hand, the straight split may be more favorable to investors if they expect the asset to turn a high profit when sold.
For example, if a property sells at a 40% profit, using an 80/20 straight split, investors would earn $32,000 on a $100,000 investment (80% of $40,000).
With a waterfall split, investors would only earn $24,400 (100% of the first 8% or $8,000, plus 70% of the next $2,000 or $1,400, plus 50% of the next $30,000 or $15,000).
Pros and Cons of Real Estate Syndication
There are advantages and disadvantages to every type of real estate investment. Here are a few to keep in mind about syndication.
- For an investor, syndications are a truly passive investment.
- Syndications are an opportunity to diversify into different types of real estate.
- Syndication projects offer access to larger properties or commercial real estate.
- Limited liability for the individual investor
- Individual investors have little to no control over the subject property.
- Poor liquidity; capital may be tied up for a period of years.
- Diluted returns.
Real Estate Syndication Crowdfunding
Prior to the JOBS Act of 2012, syndication was essentially limited to accredited investors. However, regulation A+ rules approved by the SEC opened the door for everyone to invest in real estate syndication.
Under A+ rules, sponsors can raise up to $50 million from non-accredited investors. This has led to the proliferation of online real estate crowdfunding platforms. Most of the major crowdfunding companies, such as Fundrise and RealtyMogul, now have low-minimum offerings for individual investors.
Investing In Real Estate Syndication
As with any opportunity, investors need to do their due diligence before investing in real estate syndication. Here are a few things to keep in mind about potential syndication investments:
- Many private syndication offerings are only open to accredited investors. Even those open to non-accredited investors may have other conditions for qualification. Any investor would need to check the minimum investment and time commitment to see if the investment aligns with their goals.
- Carefully read the syndication agreement. Investors should be comfortable with the split structure, voting rights, sponsor fees, and exit strategy before committing capital.
- Research the sponsor’s track record. Real estate syndication is a passive investment, which means investors have little or no control over the asset. Ensure the sponsor has experience in the acquisition and management of similar assets to the one on offer.
- Never overlook the importance of investor relations and communication. Syndicators should have a regular system for educating and communicating with investors about current and emerging issues, future plans, and performance.
Syndication is a way for people to pool their resources to purchase real estate investments that would otherwise be unattainable individually. The sponsor scouts properties, arranges deals and handles day-to-day operations while the investors have a passive role; they put up capital in exchange for a share of the profits.
Real estate syndication used to be limited to accredited investors. However, crowdfunding has opened up real estate syndicates to anyone with enough money to meet the deal’s investor minimum.
- Kulp, K. (2019.) What Is Real Estate Syndication? Millionacres. Retrieved from https://www.fool.com/millionacres/real-estate-basics/investing-basics/what-real-estate-syndication/
- Schmidt, R. (2016.) What You Should Know About Equity Waterfall Models in Commercial Real Estate. PropertyMetrics. Retrieved from https://propertymetrics.com/blog/what-you-should-know-about-equity-waterfall-models-in-commercial-real-estate/
- U.S. Securities and Exchange Commission. (n.d.) Spotlight on Jumpstart Our Business Startups (JOBS) Act. Retrieved from https://www.sec.gov/spotlight/jobs-act.shtml