Many investors see the value real estate can play in their investment portfolio. Real estate is a great investment today because:
♦️It’s a tangible asset, in scarce supply.
♦️It pays investors solid income not found in other investments, like stocks and bonds.
♦️It’s tax advantaged.
♦️It appreciates.
♦️It allows for the use of leverage to amplify returns.
♦️Equity builds over time as tenants pay down debt via rent payments.
♦️It’s a hedge against inflation and an economic slow down.
However, most people don’t have the time to identify good investments, or manage a rental portfolio and all the headaches that come with it. So, they pass on the asset class all together.
Fortunately, there is an alternative path. Real estate syndication addresses the common problem of lack of time, and the demands of “tenants and toilets,” allowing investors to participate in direct real estate ownership without the hassle.
A syndication is simply a group of investors that pool their money together to buy real estate, which in most cases they could not buy on their own individually. The “sponsor,”, “operator,” or “general partner” (GP) is an individual or company with expertise in acquisition, rehab/development, operating, and managing property. The expertise of the sponsor is likely focused on a specific asset type, for example, industrial or retail properties. At Redhawk, we focus on apartment buildings.
A passive investor is a “limited partner” (LP) in a real estate syndication. Limited partners enjoy all the benefits of direct ownership in real estate, yet have none of the responsibility or liability. LPs are able to leverage the sponsor’s team, experience, network, time, and access to deals, while having zero active management in the “day-to-day.”
Let’s look at an example for context. A $5M apartment is being purchased, with XYZ Investments as the buyer/sponsor of the deal. XYZ notices an opportunity. The units in the apartment are outdated, as the current owner has neglected some maintenance around the property inside and out. XYZ plans to infuse $1M into renovating interiors and handling maintenance that’s been deferred. In doing so, they anticipate getting higher monthly rents than are currently in-place, while also reducing expenses.
Apartments and commercial real estate are valued by the income they produce. By increasing the net operating income of the property, XYZ will increase the value of the investment for all the investors involved.
XYZ works with their lender to secure a loan for $4M, 80% of the $5M. Let’s say there is also $250K in additional proceeds needed for working capital, financing fees, inspections, legal, etc. This means XYZ will need to raise $1M for the purchase, $1M for the rehab, and $250K for the aforementioned miscellaneous expenses, for a total of $2.25M in equity capital.
That’s where the limited partners contribute. Typically minimum investments range from $25K up to $250K. Often LPs are paid a “preferred return” of 6-9%, on the pro-rata portion of their contribution, either monthly or quarterly through the life of the investment, earning a return on their income. The distributions are often sheltered from tax liability, as depreciation write-offs are utilized. At the time of sale, often within 3-5 years, the initial capital is returned. In addition, any profit made from the sale of the property would be shared between general and limited partners on a pro rata basis, with various structures to how the “waterfall” of profits are distributed.
Typically returns are higher than other investments. It’s not uncommon for annualized returns to be 20% or more. While this is ideal, it relies on proper execution by the sponsor, which is why finding quality, experienced professionals is critical. More on that later.
So is an investment like this right for you?
First and foremost, you need to know whether you are an accredited investor, as defined by the U.S. Securities and Exchange Commission (SEC). The SEC has strict guidelines as to who is allowed to invest in these types of deals, requiring compliance and tracking from sponsors. Some offerings allow for non-accredited investors, while others are only allowed to subscribe accredited investors.
An investor can qualify as “accredited” in a few ways. If an individual or married couple has a net worth of $1M or more, not including their primary residence, they qualify. Alternatively, if an individual has earned $200,000+ in income in the last two years consecutively ($300,000 combined with spouse), that would also meet the requirements. There are some nuances, but that’s it in a nutshell.
In addition to this requirement, there’s also other considerations that are personal to each individual. These investments are illiquid and typically held for 3-5 years or longer. The option of getting your money out of the deal before the property is sold could be difficult to impossible. Understanding business plans and matching deals to your liquidity needs is key.
Understanding your risk tolerance is also important. You wouldn’t want to invest in the rehabilitation of a vacant office building being converted to apartments, if you were counting on the steady cash-flow of preferred return distributions from day-one.
Now you have a better idea of what real estate syndications are and how they can benefit you as a passive investor. In the next issue of The Passive Investor we’ll cover what to look for in a sponsor and how to find them.
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