Confused on how syndication deals work? Learn the basics with our quick summary.
Investing in commercial properties, such as multi-family apartments, office buildings, retail centers is different than investing in single family homes. For new investors, it can be quite confusing. A real estate syndication deal is a transaction that pools together investor money to jointly purchase a commercial property.
Lets walk through some of the basics of the players, the legal and financial structure and how deal terms work on a simple syndication deal.
Sponsor - the sponsor is the entity or person responsible for the deal. They create the overall business plan, project financials, secure a loan, purchase/build the property, manage the property, distribute earnings to investors and decide when the property will be sold allowing investors to exit the deal. Sponsors generally contribute 5% to 15% of the total capital raised on a large commercial deal.
Lender - a traditional financial firm (i.e. bank) provides the bulk of the money to purchase or build a commercial property. The lender provides 65% to 80% of the capital required. The lender has the first lien on the property. In the event that the sponsor fails to meet their obligations, the lender can foreclose on the property.
Investors - provide the additional capital necessary to close the gap between what the sponsor is investing, the lender is providing and the total funds required to purchase, build and/or renovate the property. Investors are passive and do not take part in day to day operations or decision making.
Property Manager - the sponsor may retain a commercial property manager to handle day to day operations at the property.
Developer - the sponsor may retain a development company or construction company to either build or remodel the property as part of their business plan.
Syndication deals are generally set up as a limited liability company (LLC) structure or a partnership structure. The sponsor is the General Partner (GP) and the investors are the Limited Partners (LPs). This structure enables joint ownership in the commercial property based on the amount of equity contributed by each partner. The structure also clearly dictates that the GP has full authority and decision rights while LPs are passive investors only.
As an investor, its important to read the operating agreement and offering documents to clearly understand your rights as a limited partner.
The Financial Structure
The financial structure of a commercial deal can be quite complex. Lets start with a very basic example.
Purchase price of property: $17,000,000
Estimated renovations: $2,500,000
Closing costs/fees: $500,000
Total Project cost: $20,000,000
Senior Debt (loan from lender): $13,000,000 (interest only, 3 year term)
Sponsor Equity: $1,000,000
Investor Equity: $6,000,000
Total Capital: $20,000,000
In this scenario, investors are bridging the gap between what the lender is willing to loan (based on current value of the asset prior to rehab) and what the sponsor is contributing.
Given that investors have limited power and no decision authority, what would motivate them to participate in the deal? The opportunity for high returns!
For a sponsor to motivate investors to provide the necessary funds, they must show an attractive return for the risk that investors are taking. Since the sponsor is responsible for the full project, they must also be properly compensated for their efforts. A deal structure must be created that is a win-win for both parties.
A common deal structure for commercial deals is a tiered structure:
Preferred Returns - this is the % annual return that the investors must first realize on their investment before the sponsor receives any income or profits on the deal. Most commercial deals have a minimum of 8% preferred returns. A preferred return is NOT a guaranteed return or a return that must be paid annually to investors. It is the return that must be distributed prior to the sponsor receiving any income/profits. For example, in a 3 year deal @ 8% preferred, if the sponsor has returned a total of 5% cash to investors prior to exiting the deal, they must return another 19% to investors first. Investors must also receive all principal back before a sponsor gets profits.
Splits - Once the preferred returns are paid out, there is generally either a single tier or multiple tiers of profit sharing between investors and the sponsor. For example, the split may be 70%/30% for the remaining returns above the preferred return. In this scenario, the sponsor receives 30% of all profits once the preferred returns are paid to investors and investors then split the remaining 70% of profits.
Lets continue with our simple example from above. Lets assume that the deal structure was set up for 8% preferred return and a 70%/30% split after 8%.
The property was held for 3 years and 4% per year was returned to investors as income from operations. The newly renovated property (with higher income) is then sold at $24,000,000.
First the lender must be paid back their original loan of $13,000,000. Then investor principal is returned and sponsor principal is returned. This leave $4,000,000 in profits. Since investors already received 4% each year, they must first get their full 8%. The sponsor makes a $720,000 preferred payment to investors ($6,000,000 * 4% * 3 years). This leaves $3,280,000. The remaining amount is split between investors and the sponsor 70%/30%. Investors receive $2,296,000 and the sponsor receives $984,000.
Investors return on the deal is around 15% annualized. The sponsor's final return on the deal is around 25% annualized. As you can see, the deal structure provides a win-win model for both the passive investors and the sponsor.
Commercial real estate investing can be very complex. The above deal is a very simple example (Syndication Deals 101) that we hope will help an investor understand the basics of a deal. Before investing in a syndication deal, we highly recommend doing a comprehensive analyses of the sponsor's business plan and their offering documents. Its critical for investors to not base their investment decisions on the high level slide presentations from the sponsor. Instead, investors should do a comprehensive financial and risk analyses on the project to ensure that the project is aligned to their risk level and investment goals.
Good luck investing!