Real Life Planning Podcast Ep 44: Real Estate Syndications: Ask These 20 Questions

In Episode 44 of the Real Life Planning Podcast, Cynthia Meyer, CFA®, CFP®, ChFC®, offers coaching questions that accredited investors can ask when considering real estate syndications. She also translates jargon, explains typical roles, and gives a general overview of benefits and risks associated with these complex investments. This podcast is for educational purposes only.

" The more you know, the better an investor you will become. Put education first before you ever sign anything.” - Cynthia Meyer

This week on Real Life Planning Podcast:

Takeaway Quotes:

" Unfortunately, because this is not a regulated area of investing, there isn't a lot of transparency around the sponsor.” - Cynthia Meyer

" ..because the limited partners are providing capital only and are not participating in the day to day operations of the project, it is really a pretty hands off [type of] investment.” - Cynthia Meyer

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About the Real Life Planning Podcast

Hosts Cynthia Meyer and Vekevia Tillman-Jones explore practical steps for real estate investors to build financial freedom and make working for someone else optional.

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Episode 44 Transcript

[00:00:11] Welcome to the Real Life Planning podcast. I'm Cynthia Meyer, real estate investor, financial planner. And we're here today in episode 44 to talk about real estate syndications and questions that you should ask yourself about the syndication sponsor and the deal before you make any decisions.

[00:00:31] So quick review, what is a real estate syndication? Just so you remember, it's a partnership where multiple investors pool funds for real estate project. This partnership combines the financial resources of investors with the real estate expertise of the syndication sponsor. Typically, these are deals that are used to fund larger commercial properties.

[00:00:59] So think large apartment complexes, shopping malls, senior living centers, large student housing complexes, office buildings, et cetera. They're typically structured as limited liability companies or limited partnerships. And Those types of private investments are in a general way called real estate syndications.

[00:01:21] An important thing to know right up front is this is not for everyone. Syndication investments are for accredited investors only. And so what does that mean in real people language? That means somebody who has a higher net worth and a higher income is financially sophisticated. Now, the technical and definition of an accredited investor that you must meet in order to be provided offering documents for this type of investment is a net worth of a million dollars or more exclusive of your primary residence. Your primary residence equity does not count in that calculation.

[00:02:00] And if you're a single filer, an income of $200, 000 or higher and expected to be the same in future years. Or if you're a married couple, a married income of $300, 000 or higher and expected to be the same or higher in future years. And that's just the starting point for being able to to receive these offering documents and vet them for yourself.

[00:02:23] Practically speaking, many of the participants in these types of projects are even more wealthy and or have higher income than just that starting point. These are very financially sophisticated investments.

[00:02:38] If you meet this definition, you still want to learn a lot about it before you would consider making this type of decision. So, there are a couple of roles in a syndication that are important to understand. A syndication is a hands off investment and what I mean by that is that the investor, him or herself is not actively participating in the day to day management of the project.

[00:03:05] So the limited partners are passive investors only. They provide capital in exchange for a potential share of profits. The syndicator, otherwise known as the general partner or the syndication sponsor, manages the project from A to Z. They handle the operations, the financing, the acquisition, the reporting to invest in communication to investors. The syndication sponsor, otherwise known as syndicator or general partner manages the project. So, they have all the votes in the day to day decisions. The limited partners do not get to decide.

[00:03:42] Structurally, there are 3 components to a typical syndication deal.

[00:03:46] So, one is equity contributions. Those are investor supplied funds for the down payment, acquisition costs, and maybe some of the initial renovation costs of the project, depending on what type of project it is.

[00:04:01] Then there's debt financing. The property is financed with loans, like a construction loan and mortgages, typical commercial mortgage, for example. So, like most real estate projects, there is an equity component. There's a down payment component, and there's a leverage component that contributes to the profitability of the overall deal.

[00:04:23] Then there's a profit sharing component. So the general partners and the limited partners are going to split cash flow from the real estate project and any potential proceeds from a future sale, according to a preset formula, and that formula is laid out in the offering documents for the syndication.

[00:04:44] You'll hear the phrase waterfall free structure. That's because typically, that the initial returns up to a certain internal rate of return are returned to the majority of that cash flow. It was returned to investors first, the providers of capital first, and then the more profitable the project is over time, the higher the internal rate of return; then the general partner takes a larger share of those profits.

[00:05:14] Typically, and there's like a stair step up or waterfall, if you will, over time as the project meets those internal rate of return goals.

[00:05:24] So you may have heard a lot about the benefits of a syndication and certainly there's access to commercial real estate with a lot less capital to buy a shopping mall or an apartment complex with 3000 units, for example, takes a lot of down payment money. That's not for the average, even high net worth investor. And so investors can pool their capital to participate in a larger commercial project. That's one of the primary advantages. It allows diversification into a non correlated asset class. What does that mean? Again, in real people language, that means that commercial real estate often moves in a different direction in certain economic conditions than the stock market, for example. As the whole, commercial real estate may be zigging when the stock market is zagging, and that helps fund offer diversification in somebody's overall investment strategy.

[00:06:21] This is a truly passive investment. When we say passive income, in this case, because the limited partners are providing capital only and are not participating in the day to day operations of the project, it is really pretty a hands off investment. And there's professional management of the real estate project from the expertise of the syndication sponsor and any folks or companies that they hire to work on the project and so there are some benefits.

[00:06:50] Now, we've all heard a lot about the benefits of these types of deals, but what risks? There are some major risks. And the first and most important is that this is an illiquid type of investment. It's an alternative investment. It's highly illiquid, which means there isn't a public market for these things. You can't convert it to cash under most circumstances, and your money may be locked up for the entire period of the syndication, typically three to three to seven years, I would say is about the average could be as much as 10. Depending on the and There generally aren't ways to convert this investment to cash. So again, it depends on the deal. Generally, there isn't a way to turn in your shares and redeem them and take cash off gap. So it's in a liquid investment. Once you're in there's what I would call sponsor risk or due diligence risk and there are a few components to that.

[00:07:48] Again, the success of the investment depends on the expertise of the syndication sponsor. Have they picked the right building? The right market conditions? Have they made the correct assumptions about financial assumptions about the property? Is the loan and the interest rate appropriate? Have they picked the right people to work on the project? Contractors? Architects? Et cetera. Is it appropriately insured? Do they have good property management in place? So all of those operational skills and talents, if you will, are they good? And then there's also an ethical component. Unfortunately, because this is not a regulated area of investing, there isn't a lot of transparency around the sponsor.

[00:08:30] Those folks who are looking at a new sponsor or somebody who hasn't been tested or proven before. Or maybe they're not a really experienced investor, even though they might meet the qualifications of an accredited investor. There's some ethical risk here and that is when you're doing your due diligence, you really want to dig into that and make sure you're making a good choice with a syndication sponsor.

[00:08:54] There's market risk. And by that, things that we can't control. We can't control what happens in the economy. We can't control what happens politically or geopolitically. So there are risks in any project about the local state or national real estate market and the broader economy and political environment as a whole in the world.

[00:09:15] Operational risk, we talked about how the expertise of the real estate syndicator influences the success of the project, but there's operational risks in the day to day decisions. How the project is being managed; whether it's on time and on budget. Are the folks who are working on it, the best that you can possibly get?

[00:09:35] And then, finally, there's interest rate risk, um, the reason that's a big factor is that commercial financing tends to reset or refinance every 5 years. And consequently, a project may start out with an initial fixed interest rate for 5 years, for example, and then it's going to reset to 5 years later and that can cause all sorts of headaches if interest rates have moved far in the wrong direction. So we've seen that a lot over the past year as that some well known syndicators haven't done as well or have gone bust in particular projects because the assumption was that rates were going to stay low and in fact, they became quite high.

[00:10:16] Now we've got an idea of what the basics of real estate syndications are and who should even consider looking into them in the first place.

[00:10:26] And now, let's talk about some questions to ask if you are considering participating in a syndication.

[00:10:33] Let's start with questions to ask about the sponsor's track record. So first, what is your experience with similar deals? How many projects have you successfully completed? Can you provide references from past investors? You're looking for evidence of satisfied clients and credibility, and if possible, maybe even people that you could speak to independently.

[00:11:03] What was your performance on previous projects? Now, those syndication sponsors that is their primary role is managing commercial real estate projects, have been compiling metrics that you should be able to review return on investment, internal rate of return on equity, timeframes, risk mitigation; all of that should be transparent and clearly disclosed.

[00:11:27] Questions about investment strategy. So what type of property are we investing in and why? What's the rationale for this particular building at this time, in this market environment, in this economy? A market analysis, a rationale for the property selection. To give you an example, let's say it's an apartment building, is it near major transportation?

[00:11:53] Are there opportunities to do some minor renovations in units and raise the rent? Is there a major employer nearby or is a major employer about to be coming to the area? Is a major subway stop about to be built? Let's, for example, those. could relate to that particular project.

[00:12:10] What is the business plan for the real estate project? If you are considering one of these types of deals, you should look at it like you were making the investment in a business; a real estate business. So you want details on the acquisition on any value add strategies and an exit strategy. How will you realize the value of this investment at the end of the syndication period?

[00:12:32] What is the target rate of return and how is it calculated? So get familiar with lots of business terms: expected cash flow, internal rate of return equity multiple, for example. These are all things that you can get savvy on before you start reading syndication offering documents so that you know how to compare one to the other.

[00:12:55] The next category of questions is on deal structure. So what are their projected timelines for distributions to investors and for an exit strategy? When and how will profits be returned to investors, assuming there are profits? And so there should be a projected timeline for this may not happen exactly as planned, but there should be a plan for returning cash flow to investors.

[00:13:23] How soon cash flow gets returned to investors is very deal dependent. If it were built to rent situation, for example, for residential or commercial, that could be years before you could see some cash back. If you're buying an asset that already has tenants in it, it could be within a couple of months. So it just depends on the project that you are considering.

[00:13:45] How are profits shared between general partners and limited partners. This is very important. You should be able to see a clear explanation of the profit sharing structure and how it- or cash flow and profits going to be split between limited partners and general partners at different stages of the project.

[00:14:06] Now, as I explained before, typically, there are internal rate of return targets and the split, right? of which percentage is shared by the limited and the general partners that will change generally as the internal rate of return gets higher over the course of the project.

[00:14:24] What are the biggest risks in the project and how are they mitigated? And so this is an area where a new reviewer of syndication offering documents may not pay enough attention. It's super important. So you're talking about market risks, interest rate risks, vacancy risks, all the operational challenges. Now, some of those risks can be transferred or mitigated with insurance and some of them can't. And so you want a clear list of risks and how the syndication sponsor views those risks. One area to pay attention to if you are an accredited investor who is reviewing these documents, one area to pay attention to is if risks aren't listed or aren't included, that's generally a very bad sign.

[00:15:17] And then finally, how are fees structured, right? So when we think about the deal structure there are fees beyond the share of cashflow and sale proceeds between general unlimited partners. Typically, this syndication sponsor will also earn fees from other parts of the project. So that could be funding fees to to raise money from investors. Could be acquisition fees, property management fees, disposition fees, and so make sure you that you're asking all those questions as you read through these offering documents that you are noting what are the total fees that are paid to the syndication sponsor that's going to affect your net cash flow, obviously, just like any other investment.

[00:16:00] The next category of questions is on investor updates. How is the general partner communicating with the limited partners? How often will updates and financial reports be provided? Hopefully, you'll be getting more than just a K1, right? Is there an investor portal that you can log into? Are you getting some communication monthly or quarterly? How transparent is the communication going to be? Again, generally, the longer the track record of the syndicator and the larger they are, they may have a more formal process for investor communication than, say, a new first time syndicator, but frequency and transparency of communication is something you want to know upfront.

[00:16:41] And then when you exit early, and if you can exit early, what is needed to do that, right? Are there any options for liquidity or resale? Now, again, often the answer is no, there aren't any options for liquidity or resale, but if there are, you want to know what they are.

[00:16:58] Then ask some questions in the category of operations and legal. Again, remember, if you're an accredited investor that is considering something like this, you want to ask lots and lots of questions about, you as the hands off investor, how is the hands on team going to be managing things on a day to day basis? Who will manage the property daily? What's their team experience in their property management qualifications?

[00:17:25] What happens if the project under performs? That's a super important question to ask.

[00:17:32] Will there be capital calls? Are the limited partners required to put more money into the if the project is not on track? Or will there be a process of polling, for example, the members to see if they want to sell the project to the loss or put more money in?

[00:17:50] What are the contingency plans transcribed for delays and financial shortfalls? You also want to make sure that just like any business; they have emergency cash reserves that they were appropriate insurance, et cetera.

[00:18:02] What's the legal structure of the syndication? Again, making sure you understand your rights as an investor, your liabilities, and any potential tax implications. Those are good things, by the way, to discuss with your tax advisor and or your attorney.

[00:18:18] Is the syndication sponsor personally investing in the deal? So does the sponsor as a company have their own money in the deal? Do the members of the sponsor company have their own money in the deal? Do they have skin in the game that shows alignment with the interest of their limited partner investors?

[00:18:40] Other considerations when reviewing sponsors and asking all these important questions is if you are in the midst of a 1031 exchange, or you would like to fund participation with funds from a 1031 exchange? Know that generally doesn't happen. The structure of a typical syndication would not allow for taking funds from a 1031 exchange. However, if it's a small syndication project, and it is a large 1031 exchange that you're in the middle of, you may be able to work something out. You have to contact the sponsor directly and see if they're willing to spend the extra money and time to create attendance and common structure so that you would be able to participate with 1031 exchange funds. Again, not super common to happen. But if it's something that's important to you, you want to start asking questions about it up front. Otherwise, it's not you wouldn't be a potential replacement property for you.

[00:19:36] And then finally, as a broader point of view, I want to invite you to be skeptical. Watch out for marketing pitches that are overly salesy.

[00:19:51] Now, it's totally normal for an experienced sponsor to put together a polished brochure and webinar and PowerPoint presentation about the deal, but that has to be backed up with lots of legalese and disclosures in the offering documents. Something that is just too salesy that represents all of the benefits and none of the risks in the property is generally not a good sign.

[00:20:22] This is an area of investing that is not regulated. It's not transparent. This type of alternative investment available only to accredited investors, is very financially sophisticated. Unfortunately, it's an area in which there has been some bad actors and vetting your sponsor to make sure you're doing due diligence, it's not to protect you from all types of market risk, or the rest of the particular project, but it can help protect you against- in weeding out some of the bad actors in the space.

[00:20:56] So how can you learn more if you're interested in getting involved in this type of investment? How can you learn more? One is you can work with a financial advisor who has lots of experience with alternative investments and can help vet them for you. Right now, that could be pricey, but it could but that is definitely something that you can do. There are registered investment advisors that specialize in alternative investments. So that's one thing that you could do.

[00:21:23] If you're more of a DIY investor, you can get smarter about all things private real estate. Couple of things you can do. You can participate in the Bigger Pockets- has a new service called Passive Pockets where they are just at the beginning stages of building a portal where they are soliciting reviews. First syndication sponsors from other investors who've participated in deals. They are trying to build a systematic way for organizing information and offering some initial due diligence on the process to accredited investors. So that's something to do. They're really just getting it off the ground. So not that much there yet, but definitely something worth looking into and not that expensive.

[00:22:09] The other thing you can do is just sign up for some of these crowdfunding portals that offer syndications. That's assuming you're an accredited investor and just look at deals. Look at deals, go to webinars, download their brochures, read the offering documents. Take these list of questions and then all the other types of questions that you can think of yourself and just start reading through these documents and making notes for yourself. Find a way to compare and contrast. By the time you're ready to consider doing this for yourself, that you really understand what you're looking at, what you're reading, what are the questions that you're going to ask of the syndication sponsor so that you can help make better decisions.

[00:22:58] Always make sure you can talk to your attorney, talk to your accountant, talk to your financial advisor, financial planner, and participate in real estate study groups where you can learn more about these types of larger commercial real estate projects. The more you know, the better an investor you will become. Put education first before you ever sign anything.

[00:23:24] So I hope that's been helpful to you. Again, we'll put the whole list of questions in the show notes and if you've got comments, leave them below and we'll see you next time on the Real Estate Planning Podcast.

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