Real estate is one of the best asset classes to build long term wealth. Unlike stocks, real estate just doesn't go *poof* in one violent downturn. Finding a great real estate syndication deal takes time, but they are out there thanks to new online real estate crowdfunding platforms.
Real estate is a physical asset that generates cash flow (rents). Often times, rents are sticky during a downturn because of year-long leases or tenants who stay put and aren't willing to renegotiate downward.
Further, with interest rates way down, partially due to the pandemic, the value of cash flow (rents) has gone way up. In other words, it takes a lot more capital to produce the same amount of risk-adjust income.
Instead of owning physical property, which sometimes can be a pain to manage, sophisticated investors are looking more towards real estate syndication deals to earn returns more passively.
After selling my San Francisco rental home in 2017 for 30X annual gross rent, I decided to reinvest $550,000 of the $1.8 million in proceeds in several real estate syndication deals.
I was a new father who didn't have time to deal with tenants and maintenance issues. Besides, San Francisco real estate prices were outrageously high. And I wanted to use my expensive capital to reinvest in the heartland of America where valuations are much lower and net rental yields are much, much higher.
We're talking 2.5% cap rates in San Francisco versus 8%+ cap rates in Austin, Texas and Charleston, South Carolina. Let's learn more about real estate syndication and how to invest through them.
What Is A Real Estate Syndication Deal?
A real estate syndicate is when a group of investors (limited partners) put money into a real estate transaction put together by a sponsor.
To participate in a real estate syndication usually requires the following:
- Accredited investor. You need to either earn more than $250,000 as an individual or $300,000 as a married couple, or have at least $1 million in assets outside your primary residence.
- Connections. To invest in the syndication you need to know the Sponsor. Alternatively, you can get an invite by a limited partner to invest.
- Have a fundamental understanding. Never invest in something you don't understand. You must understand what type of real estate investments are being made, the time line, and the return objectives.
In a real estate syndication, the Investors contribute money into the deal and the Sponsor commits their operating expertise, know how, and often times their own capital to demonstrate skin in the game.
If the Sponsor is not committing any of their capital in the real estate syndication, I encourage you NOT to invest. The Sponsor needs to feel the pain of a bad decision if the investment goes south.
Real Estate Syndication Structures
The structure of real estate syndication deals is usually a Limited Liability Company (LLC). But sometimes they are a Limited Partnership (LP). In the case of an LP, the Sponsor is the General Partner/Manager whereas the Investors are limited partners or passive members.
Read The Documents Carefully
This means that your organization will have Operating Agreements (LLC) or a Partnership Agreement (LP). You will want to read this carefully. They outline how distributions are paid out, how voting rights are established, as well as any fees the Sponsor gets prior to distributions. Everything important is in one of those documents.
Waterfall Structure
Syndication deals have a lot of different structures. For example, some syndication deals have a “waterfall structure” where some limited partners get paid before other. Here's an example:
- First, Class A Investors get 8% on their contributions (preferred return);
- Then, Class A Investors are distributed 70% of the remaining distributable cash;
- Then Class B Members (Sponsors) get 30% of the distributable cash.
Of the distributable cash, Investors will get 8% on their investments before the Sponsors get a share of the rest. This, and much much more, are outlined in the Operating Agreement.
As an Investor (Limited Partner), you must understand the structure of how you will get paid based on performance.
One of the main reasons for creating an LLC is to protect the Sponsor, not the Investor. If the deal turns south, the Sponsor doesn't want Investors coming after their other assets.
Real Estate Investment Return Metrics
There are five main investment return metrics to understand. They are:
- Return of Investor's Capital – How will your money be paid back to you. Often, the investors are paid back first before the sponsors.
- Preferred Return – On distributions, preferred return is how much get paid to investors first. In the above case, the preferred return is 8%.
- Catch-Up Clause – If present, the sponsor gets 100% of distributions up to the catch-up clause before carried interest. In the above case, there is no catch-up clause.
- “Carried Interest” – After all is said and done, this is how the profit is split between investors and sponsor. In the above case, the split is 70/30.
- Internal Rate Of Return (IRR) – You want to know what the Sponsor's estimated IRR is for the life of the project. The IRR is what you, the Investor will hopefully get once the deal is completed. Just beware of overly optimistic IRR assumptions. A good rule is to cut the IRR assumption in half to stay conservative.
Real Estate Syndication Fees
There are also fees to be aware of that act as a drag on your investment returns. You must have the Sponsor make clear all their fees and ask them about their expected IRR net of fees.
- Acquisition fee – This is the fee for closing the fundraising. It includes finding the deal, organization, and purchasing the property.
- Financing fee – If there is financing, this is the fee for procuring the acquisition loan.
- Management fee – This is how much the sponsor is receives to manage the assets of the company.
- Property management fee – This is how much the sponsor gets to manage the property.
- Disposition fee – This is how much the sponsor receives when the property is sold.
At the end of the day, you want to pay the lowest fees and get the highest returns.
Easiest Way To Invest In A Real Estate Syndication
Even if you are an accredited investor, you might not have the connections to invest in a real estate syndication deal. This is where real estate crowdfunding comes in.
Since the passage of the 2012 JOBS Act, real estate crowdfunding marketplaces have emerged to allow both accredited and non-accredited investors alike to invest in real estate syndications.
Real estate crowdfunding marketplaces analyze all the deals before they reach their respective platforms. This is a huge value-add for many investors who don't know where to start. Further, real estate crowdfunding platforms are incentivized to only allow for the most promising projects to keep investors coming back.
Below is the Fundrise vetting funnel for real estate deals on their platform. Only around 1% of the deals they see get through for investors to consider, which is why they are one of my favorite platforms today.
With real estate crowdfunding, you don’t need to risk $100,000 or more to invest in commercial real estate. Remember, buying physical real estate can be a highly concentrated bet. Instead, you can invest as little as $1,000 and be much better diversified.
The two best real estate crowdfunding platforms today are:
1) CrowdStreet is based in Austin and connects accredited investors with a broad range of debt and equity commercial real estate investments. CrowdStreet is great because they focus primarily on 18-hour cities (secondary cities) with lower valuations, higher net rental yields, and potentially higher growth. They also occasionally offer funds.
2) Fundrise, founded in 2012 and available for accredited investors and non-accredited investors. Fundrise is the creator of the private eREIT, or private real estate funds. I’ve worked with Fundrise since the beginning, and they’ve consistently impressed me with their innovation.
Invest With The Best REC Marketplaces
Both of these real estate syndication platforms are the oldest and largest platforms today. They have the best marketplaces and the strongest underwriting of deals. Sign up and take a look around as it’s free.
As always, do your own due diligence and only investment in what you understand. I personally have $810,000 invested across 18 different commercial real estate projects around the country. My current internal rate of return is about 12% since the end of 2016.
Earning income 100% passively as I diversify my real estate holdings has been wonderful now that I'm a busy full-time father of two young children.
About the Author:
Sam started Financial Samurai in 2009 as a way to make sense of the financial crisis. He proceeded to spend the next 13 years after attending The College of William & Mary and UC Berkeley for b-school working at Goldman Sachs and Credit Suisse. He owns properties in San Francisco, Lake Tahoe, and Honolulu and has a total of $810,000 invested in real estate crowdfunding.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $220,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.
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