NEW BOOK BY ADAM GOWER PH.D.
Capital Calls and RESCUE Capital
A guide to thriving during the coming real estate crash for real estate syndicators and their investors.
What are the Different Phases of Real Estate Syndication?
In many ways, syndication is the Holy Grail of real estate investing.
Passive investors regard it as the most hands-off way to generate “mailbox money” from real estate. On the other hand, career real estate investors often covet the role of syndication sponsor, hands on the reins of a huge deal.
Either way, it is easy to look at syndication as the Super Bowl of property investment. It can even become intimidating. From the purchase contract to the private placement memorandum, stacks of due diligence paperwork to sort through and loan documents to sign ... the process sure seems complicated.
At its heart, however, real estate syndication is relatively simple. It’s just like any other real estate investment, only on a larger scale. Like any real estate investment, a successful real estate syndicate moves through three phases:
- The Organization Phase
- The Operation Phase
- The Liquidation Phase
What is real estate syndication?
Real estate syndication allows investors to pool their money to purchase a single property — often a large commercial property like an apartment complex, office building, retail center, or industrial facility.
Syndication investors do not directly own the real estate itself, but rather they own a share of an entity — a corporation, trust, or LLC — and that entity holds the investment property. In this sense, a syndicate is a kind of capital fund backed by real estate. It resembles a REIT in the sense that investor capital is pooled, but most REITs hold many properties, sometimes hundreds or thousands, whereas syndicates are typically just one property. REITs are also subject to disclosure, distribution, and tax related regulations that syndicates are not.
A syndicate is usually created and managed by an active partner called a sponsor. Other participants subscribe to (i.e., invest money in) the syndication as a passive investor, with no operational responsibilities for the property.
Pros and Cons of Real Estate Syndication
Pros
- Economies of Scale. Investors can pool their funds to buy properties they could not afford individually, taking advantage of the economies of scale available from larger properties.
- Diversified Risk. Larger tenant bases make vacancy expenses more manageable. Investors can also invest smaller sums of money into a greater number of units or assets.
- Leadership Structure. The sponsor assumes all of the operational responsibilities, reducing the confusion of “too many cooks in the kitchen.”
- Favorable Financing. Syndicates can often access favorable terms from commercial lenders — terms not available to smaller, individual investors acting on their own account.
- Illiquidity Premium. Investors in syndicates typically cannot divest of their ownership shares and so are typically compensated for this by enjoying higher returns relative to investments that can be bought and sold quickly and easily.
- Non-correlation with the Stock Market. Being so highly tradable, stock prices can be very volatile and subject to the news cycle, changing value by the second. Investments in real estate syndicates, however, being illiquid, and not generally subject to the whims of market sentiment or volatility.
Cons
- Less Liquidity. Syndication shares can not usually be traded on secondary markets like, for example, shares of a stock or REIT can, making them limited in their liquidity.
- Passive Investors Have Little Control. Cash investors must often give up control over the asset to the sponsor. If the property underperforms, the passive investors have little recourse to insist on changes, though they can replace the sponsor in extreme circumstances.
- Qualification. Syndication investors must usually be either accredited or sophisticated investors.
Phase 1- The Origination Phase
The origination phase involves identifying the property, performing due diligence, obtaining financing, and closing the deal. The sponsor usually performs the following tasks during the origination phase:
- Engage in marketing and networking to find the right deal.
- Underwrite (analyze) the deal to project its profit potential.
- Negotiate the purchase contract.
- Create a business plan for the property.
- Audit the property’s financial records.
- Perform physical inspections on the property.
- Validate the title and cure any impediments to closing.
- Shop for real estate loans and apply for the most appropriate loan.
- Assemble loan guarantors (if necessary) and order commercial appraisals.
- Create the entity (LLC, corporation, etc.) that will hold the asset.
- Raise cash from passive investors for the down payment, closing costs, and immediate needs or renovations.
- Close escrow.
- Commence execution on their business plan.
The origination phase usually lasts several months, from property identification to close of escrow.
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Phase 2- The Operation Phase
In the operation phase, the sponsor executes the business plan created in the origination phase, often with a professional property manager and other contractors.
In the early phases of the syndication, this might include:
- Curing any deferred maintenance.
- Fulfilling any repair requirements set by the lender.
- Executing a renovation plan.
- Executing a lease-up, renewal, or rent-increase plan.
After the initial “value-add” phase, the operation phase could continue for several years. During this time, the sponsor (in collaboration with the property manager) is responsible for:
- Collecting rent.
- Performing routine maintenance.
- Negotiating contracts.
- Marketing and leasing vacant units.
- Settling legal disputes, including evictions.
- Paying mandatory expenses like property taxes and insurance.
- Making debt service payments.
- Distributing cash flow payments to the passive investors.
- Making regular reports on the physical and financial condition of the asset to passive investors.
- Prepare tax returns for the asset. Sponsors must furnish passive investors with Form K-1 for their own tax returns.
Phase 3- The Liquidation Phase
The liquidation phase involves a “liquidity event” that returns capital to the investors. This could be the sale of the asset or refinance of the loan.
In the event of liquidation by the sale of the asset, the sponsor is usually responsible for the following tasks:
- Making any repairs or upgrades required to make the asset appealing to buyers.
- Prepare the financials for buyer inspection.
- Market the asset to potential buyers, often with the help of a broker.
- Facilitate buyer tours.
- Review offers.
- Negotiate the purchase contract with the winning buyer.
- Close escrow.
- Pay passive investors their portions of the proceeds.
- Prepare the final tax returns and Form K-1s.
In the event of liquidation by refinancing, the deal sponsor will probably:
- Shop lenders.
- Apply for a loan.
- Arrange loan guarantors and a new appraisal.
- Close on the new loan.
- Distribute loan proceeds to passive investors.
After refinancing, the operational phase may continue for several years until the final liquidation event (the property’s sale).
Summary
While real estate syndication looks complicated to a newcomer, every syndicate moves through three identifiable phases:
- Origination. Find the asset, perform due diligence, close the deal.
- Operation. Execute the short-term and long-term business plan.
- Liquidation. Sell or refinance the asset to cash out.
CONCLUSION
Massive commercial real estate investments have a lot in common with smaller investments. The numbers get bigger, but the strategies are essentially the same—buy, rehab, rent, refinance, sell, repeat.
Large commercial properties may seem like the province of the super-rich. But for investors who do not have millions of dollars in cash to commit to a single property, real estate syndication puts these kinds of investments well within reach.
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