Syndication Terms
Syndication
A real estate syndication is a way for multiple investors to pool their money and resources together to purchase a larger real estate investment than they could on their own.
This is typically done through a limited liability company (LLC) or limited partnership (LP) structure. The syndication is led by a sponsor, who is responsible for finding the deal, managing the investment, and providing returns to the investors. In exchange for their investment, the investors receive ownership in the LLC or LP and a share of the profits from the investment. This allows investors to diversify their portfolio, participate in larger deals, and benefit from the knowledge and experience of the sponsor. It's a powerful tool for those looking to grow their wealth through real estate investment.
A great example of this concept is when a group of investors bought the Empire State Building in the 1960s. Some people invested as little as $10,000 to be part-owners of the $65M property.
Real Estate Investment Trust (REIT)
A REIT is a publicly traded company that owns and operates income-producing real estate properties. Unlike with a syndication, you can cash in and cash out quickly with a REIT, just like you’d buy and sell stocks. The owners of the Empire State Building, because it was doing so well, eventually transitioned their syndication into a REIT, which then effectively allowed anyone to invest in it on the stock market.
General Partner/ Limited Partner (GP/LP) vs Sponsor/Investor
Syndication deals are created and run by a Sponsor (also sometimes referred to as the syndicator, operator, asset manager, or General Partner (GP)). A sponsor can be either an individual or company. The sponsor finds an opportunity, raises the capital, executes the acquisition, and is responsible for the day-to-day operations. The investors (also sometimes called Limited Partners (LP)) are passive players in the syndication game. They typically don’t bear the legal liability that the sponsors do and are not involved in the day-to-day operations. The investors will often get status updates and disbursements from the cash flow of the investment, as determined by their ownership percentage and the subscription agreement of the syndication.
Regulation D Offering (Reg D)
This term refers to the typical type of offering that syndicators use. Reg D is part of the U.S. Code of Federal Regulations that allows these syndications to be exempt from filing with the Securities and Exchange Commission (SEC), as opposed to publicly traded companies.
Sophisticated vs Accredited Investors
A Sophisticated Investor is someone who understands that there are winners and losers when it comes to investing, and that there are always risks and never any guarantees in any investment opportunity.
An Accredited Investor is someone who has a specific amount of money that they have made, whether in stock holdings, cash, or another form—it’s also called their net worth.
There are specific guidelines in every syndication, such as that an accredited investor must have made $200,000 over the past two years.
506B versus 506C Offering—(Under Reg D)
Sophisticated investors and accredited investors are both allowed to invest in 506B offerings. These offerings cannot be advertised publicly, so they work best with investors with whom you have a preexisting relationship. Only accredited investors are allowed to invest in 506B offerings. These offerings can be advertised publicly.
Syndication Documents
The first time you consider a real estate syndication can definitely be confusing and a bit scary. There are four main documents to review and sign:
Private Placement Memorandum (PPM)
The PPM is the main disclosure that describes the structure of the syndication entity (typically an LLC or Limited Partnership (LP)). The PPM will describe the risks involved in the syndication and how it’s not a traditional liquid investment like the stock market.
Operating or Partnership Agreement
This document will discuss things like duties of the sponsors and investors, voting rights, bylaws, etc.
Subscription Agreement
In this document, an investor will certify that they meet the requirements of the 506B or 506C syndication and explain how much they plan to invest in the opportunity.
Business Plan or Investor Pitch Deck
This document describes the details of the investment itself as well as future projections. The pitch deck is normally presented to investors in some form when the investment offering begins. Webinars are a common tool used to disseminate this information quickly.
Profit and Loss Statement (P&L)
The P&L is simply the financial statement that shows the income and expenses. Your ability to read a P&L (or at least generally understand it) will be very helpful when analyzing investment opportunities.
Trailing Three or Twelve Months (T3 or T12)
Looking back at a property’s historical performance is an important aspect in deal analysis, so you’ll often see investors request the Trailing Twelve Months of financial statements (or T12). To try to get a more accurate measure of recent income trends and also long-term expense trends, it’s very common to take the T3 income, annualize it (i.e. take the average and multiply it by twelve months), and then subtract the T12 expenses to calculate a conservative estimate of the NOI, which is an important variable in determining value.
Debt Coverage Ratio (DCR) or Debt Service Coverage Ratio (DSCR)
These terms, which are used interchangeably, both refer to a metric of an investment’s net operating income (NOI) versus its debt obligation (i.e. interest and/or principal paybacks to the bank or any lenders to whom you owe money). DSCR gives the lenders a metric of how healthy an investment is and how much buffer a borrower has to pay back their debts after paying their expenses. Lenders will often want to see a DSCR of at least 1.25. [DSCR = NOI/Total Debt Service]
Rent Roll
The rent roll is an itemized report of each unit in any sort of income-producing property. It shows who is occupying each unit (or if a unit is vacant), payment history, security deposits, how long the tenant has been in place (along with their lease expiration date), etc. After an investor gets a deal under contract, it’s important for them to verify that the rent roll they received as part of their initial due diligence is accurate. For example, if the rent roll says Sally Smith lives in unit 8A, but during inspection an investor finds that unit 8A is vacant, they are looking at a discrepancy that will affect their bottom line.
Ratio Utility Billing System (RUBS)
Not all investment properties are sub-metered, meaning each tenant may not have their own water and/or electricity meter. When a property is “master metered,” meaning it has a single meter for all tenants, a cost-effective way to have the tenants pay for utilities is through a RUBS. To create this system, the owner splits up the utility bill so that everyone pays a fair share. The fair share can be based on all sorts of variables such as number of bedrooms, square footage, number of occupants, etc. It’s rare that owners will split up 100% of the utility bill and important that they don’t make a profit from a RUBS. Otherwise, they are acting as a utility company and subject to additional oversight and regulations.
Capitalization Rate (Cap Rate)
To determine value in commercial real estate, you cannot simply look at comparable sales (which is the common method for determining value in residential real estate) because there are too many differences between one property and another. Instead, value in commercial real estate is determined by how much money a property can produce (i.e. a property’s Net Operating Income (NOI)). Cap Rates are the metric used to compare commercial property values within a metropolitan statistical area (MSA) by looking at known sale prices and their respective NOIs. Simply put, it’s just the NOI divided by the value.
Cap Rate = NOI/Value
In practice, you use the Cap Rate of one property to determine the value of another. If you know that Apartment Complex A has 100 medium-sized units, recently sold for $10M, and made $600K in NOI last year, you determine the Cap Rate is 6% by using the formula above.
You can now apply that Cap Rate to Apartment Complex B, which you are considering purchasing. It has 65 nice, medium-sized units and made $500K last year. You use the formula of Value = NOI/Cap Rate and determine its value is $8.3M.
Basically, the Cap Rate is the ‘going rate’ in the area, and it’s a way to make reasonable comparisons. It's also worth noting that when Cap Rates go down, property values go up.
Acquisition Fee/Asset Management Fee/Capital Transaction Fee
These fees are three common types you’ll see on syndication deals.
Acquisition Fee
This is a percentage of the purchase price that is paid to the sponsor (or GP) for getting the deal set up and executed. Common acquisition fees range from 1–2%.
Asset Management Fee
This is an ongoing fee to the sponsor for their work managing the asset (i.e. the property purchased through the syndication); the asset management fee is separate from the property management fee because the sponsor is generally managing the bigger picture. I like to say that the asset manager manages the property managers—it’s a lot of management, but it’s an important role to a successful syndication. Asset management fees normally range from 1–5%.
Capital Transaction Fee
This is a fee paid to the sponsor upon the sale of the property as a reward or payment for their hard work in getting the sale to happen when you complete an investment opportunity. I normally do not charge a capital transaction fee as a syndicator, but when people do charge them, 1–2% of the sale price is a normal range.
Preferred Return (Pref)
When discussing investment opportunities with LPs or investors in our syndications, we cannot guarantee any returns. By nature of an investment, anything can happen to an investor's money, and we cannot ensure they will make any money back at all. To create confidence in a deal, however, we can offer a Pref, where we promise that all extra cash flow will go to our investors first until they are paid this preferred return.
For example, let’s say you invested $120,000 into a syndication with a 10% preferred return; that percentage breaks down to a $12,000 pref per year (or $1,000/month or $3,000/quarter). In this example, the distributions are paid quarterly to the investors. Let’s say that based on your investment and LP ownership percentage, there is enough cash flow to pay out $4,000 in the first quarter. The first $3,000 would go to you to cover your pref, and, typically, the remaining $1,000 would be split between the LP and GP based on their ownership percentages.
What happens if the preferred return isn’t covered? Most syndications will offer a cumulative (but not compounding) return structure. So, for the example above, if the cash flow only paid for $2,000 in that first quarter to the investor, they would be owed an additional $1,000 in the following quarter on top of the expected $3,000 (i.e., a total of $4,000) to ensure that all cash flow goes to them until they hit that minimum pref of 10% annually.
Waterfall Payment Structure (Waterfall)
Here is where returns between sponsors and investors can get complicated. In a waterfall, the cash flow splits change based on the amount of capital that is paid back to the investor.
For example, let’s say a waterfall offers a preferred return of 6%, followed by a 70/30 split based on partnership status (LP/GP %) for a 6–8% return, a 50/50 split for an 8–10% return, and a 30/70 split above a 10% return. This structure incentivizes the sponsor to perform as strongly as possible; the higher return the sponsor pays the investor, the larger the payday for the sponsor.
I’m definitely a fan of the KISS method—Keep It Simple, Stupid!—so if I use a waterfall structure in my syndications, I try to keep it as simple as possible. (A confused mind tends to answer any offer with a “no,” so I try to not confuse my investors so I have a chance of getting a “yes”! )
Depreciation vs Appreciation
As real estate agents, we understand the concept of appreciation. Generally, we like to see broad and continual appreciation of the market and our clients’ home values. However, one massive benefit to owning investment real estate is that the IRS allows you to view that purchase as a depreciating asset from the moment you buy it.
Just as a car loses value the moment you drive it off the car dealership lot, the IRS allows us to view our investment properties the same way.
Per IRS Publication 527, commercial real estate depreciates over a period of thirty-nine years while residential property (which includes multifamily properties) depreciates over twenty-seven and a half years. After those time periods, the properties cannot depreciate any more (i.e. their depreciation basis is $0).
Keep in mind, however, that the actual land does not depreciate––dirt is dirt is dirt. It’s the improvements on the land that depreciate. These improvements are of course buildings, roads, sewer systems, etc.
How does depreciation help you as a rental property owner? As an example: If you had $10K/year in depreciation, it is basically a paper-only expense. If that property produces $12K of taxable income in a year, you can effectively subtract the depreciation expense to reduce your tax burden. In this example, you’d subtract your $10K in depreciation from the $12K in taxable income, which would result in you only having to pay taxes on $2K of rental income. Obviously, there are more variables to consider in terms of write-offs and taxes, but this is a simple way to see how depreciation can save you money in the near term!
It’s worth noting that this isn’t a free gift from Uncle Sam. When you go to sell your property that has been depreciated, you’ll have to consider depreciation recapture, but we’ll discuss that topic another time!
Cost Segregation Study (Cost Seg)
While the depreciation previously discussed is one of the benefits of owning rental property in the United States, a Cost Seg really allows you to maximize that benefit! A cost segregation study involves segregating––or separating out––individual components in a property when calculating its depreciation.
To do a Cost Seg on a rental house, you would typically pay a specialist to come to the property and identify all its components based on their lifespans. For example, the flooring in a property may not have that lifespan of twenty-seven and a half years that the IRS uses to determine depreciation for the entire house––its lifespan may be just five years.
By separating out the lifespans of the different items, you’re able to depreciate those individual items even faster and enjoy more tax savings now. The current tax code even allows for bonus depreciation, which allows us to accelerate a certain percentage of the items with a twenty-year lifespan or less into the first year for huge savings.
My clients and I have deferred hundreds of thousands of dollars by leveraging cost segregation studies and accelerating depreciation. It is the government's way of incentivizing real estate investors to spend investment dollars on housing and real estate in America. These few paragraphs barely scratch the surface on this topic, so I highly recommend spending the time to understand this topic!
De Minimis Safe Harbor
The IRS defines this term as “an administrative convenience that generally allows you to elect to deduct small-dollar expenditures for the acquisition or production of property that otherwise must be capitalized under the general rules.” Stated more clearly, a De Minimis Safe Harbor allows you to add items as an expense rather than capitalize that purchase on items of $2,500 (or in some cases $5,000). It’s a way to save on taxes in the near term rather than waiting on the depreciation savings down the road.
Proforma
A proforma is the projection of how an investment is expected to work out in the future. It lists the expected future incomes, expenses, assumptions, NOI, etc.—the variables by which most investors will decide if an investment is an opportunity that they would like to pursue.
Low Income Housing Tax Credit (LIHTC)
The LIHTC is a federal and state program that provides a tax incentive to build and/or rehabilitate affordable rental housing for low-income households. It’s another program that highlights the tax benefits of investing in real estate.
Class A/B/C/D Properties and Areas
This classification system is a way to label the quality of a property or area. It gives investors a general understanding of a property or area but, due to its subjectivity, it’s a limited system. For example, a class A apartment complex would be one that is in great shape with a lot of amenities such as a pool, gym or even coffee shop on-site. A class B complex would be one that is nice with few amenities. A class C complex would be one that is safe and clean without any extras. A class D complex would be one that is inadequate in most or every way. Area classifications are similar: a class A area would have a lot of wealth, high-quality homes, great schools, amenities, and restaurants. A class B area would have good homes and schools but not as many home-owners associations (HOAs) or amenities. Class C would have a lot of lower-middle class housing, no HOAS, yards that are not always kept up, and only passable schools. Class D or section 8 housing areas would be undesirable in most ways.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBDITA)
This metric measures the profitability of a company. Some investors will use this term synonymously with the Net Operating Income of a real estate property.
