It’s a tried and tested rule of wealth-building thumb: One of the best ways to become a millionaire is through real estate investments. But what makes your next real estate purchase an investment property? And when we say real estate, we’re not talking about buying a house to live in. But a property that makes you rental income from tenants or profits from resale.
In this video, Investopedia breaks down the nuts and bolts of what actually makes an investment property.
How To Put That Extra Space In Your Property To Good Use
A lot of investment properties have something we call bonus space.
It’s space that isn’t quite a bedroom, maybe not really living space, but doesn’t have any one specific use.
So, how do you use this space to create value for your investment property?
Well, that depends…
Can It Become A Bedroom?
A bedroom is almost always going to be the highest value use of any bonus area, so let’s try that first. So, it’s time to look up your local health/building codes to determine the requirements for a bedroom.
The International Residential Code, which most states follow, has several requirements to be considered a bedroom. States and municipalities are free to add on top of this, and some areas don’t use the IRC as their code.
Most places have a square footage requirement and also require a window and a closet. But, different states/municipalities may have different requirements so look them up.
Note About Egresses
Basements and Attics are notoriously bad places to be during a fire. There may be requirements for additional egresses for any living space that is in these two areas. Make sure you know all of the requirements before trying to make a bedroom.
Once you know the requirements, you can determine if a simple project can convert this random bonus space can be used as a bedroom.
For example, if it just needs a larger window, simply hire someone to install it. If you need a closet, get one put in.
It becomes more challenging if you need another egress added to a basement though.
10 Mistakes Homebuyers Must Avoid At All Costs
Buying your home can be quite daunting, and if done wrong, it can bring with it enough financial regrets for the homebuyer. Here are 10 mistakes to avoid when buying your home.
How To Make Real Estate Syndication A Success Without Using Your Money
Have you ever driven around your city and seen all these apartment complexes, shopping plazas, or even office buildings? I always used to think they were all owned by rich billionaires.
…some of them are, but not all.
The reality is that a lot of these large properties are actually owned by regular people like you and me to generate passive income.
The answer: with real estate syndication.
It’s what I used to recently close a 192 unit deal in San Antonio with my partners.
But what exactly is real estate syndication?
Syndication is a way which multiple real estate investors pool their funds together in order to purchase a property that is more expensive than any of them could have afforded on their own.
Generally, there are two types of partners in these deals: 1) General Partners (GPs) who accept additional risk, put the deal together, and operate the asset 2) Limited Partners (LPs) who have limited risk and invest more passively.
Real estate syndications are an effective way to spread risk. Since each investor can allocate a smaller sum to each deal, they can effectively spread their risk across multiple property types and diversify by geographic region.
Real Estate Syndication Structure
Syndications in real estate are amazingly diverse in their structure so it’s impossible to cover everything. In general, there are four components:
- Return of investor capital – Limited partners should always get paid back first, and this ensures they get paid first
- The preferred return – Not all deals have a preferred return, but when they do this is where it pays out. Investors get the first portion of the deal before the general partners.
- The catch-up – Many deals don’t have a catch-up tier but this is where the sponsor will get 100% of the profits after the preferred return until the predetermined split is met.
- Carried interest – profits are split based on the agreed amount (such as 80/20 or 70/30)
Let’s break it down further…
What Is A Preferred Return In A Real Estate Syndicate?
According to Mark Kenney over at ThinkMultifamily, a preferred return is “a return that investors received BEFORE the general partners receive a return.” In essence, after the investors receive their initial capital back, they received a preferred rate of return before the general partners get any payout at all.
Mark, an investor and real estate coach who owns over 2,000 doors in Tennessee, Georgia, and Texas, says that he doesn’t like to use a preferred return but has in the past on deals that didn’t expect any distributions for 12 or 18 months.
The preferred return would accrue and give incentive for people to invest in the deal.
Andrew Campbell, the co-founder of Wildhorn Capital, a multifamily operator based in Austin, Texas has a different opinion. He said he likes to have an 8% preferred return for the majority of his 450 door portfolio.
It “gives some certainty to investors about their overall returns. Plus, 8% also happens to beat the historical stock market return of 7%.”
What Is A Waterfall In A Real Estate Syndication?
The waterfall refers to the overall distribution of funds and tiers that were mentioned above, but it is often referred to as how profits are split after the preferred return is met. Andrew Campbell explains it perfectly:
“Profits generated above any preferred returns are generally split between investors (Limited Partners) and deal sponsors (General Partners). In our case, above the 8% pref we split profits 70% to Limited Partners and 30% to General Partners.
Some deals and sponsors will have additional “waterfalls” where at 18% IRR (for example) the split would go to 50/50. The general idea is that the higher the returns are to investors, the more the sponsors make, and everyone is happy.
The downside of multiple waterfalls is that sponsors can sometimes be incentivized to return investor capital early (to boost the IRR) and trigger these waterfalls.That can sometimes put unnecessary risk on the asset if they are being to aggressive.”
Kenny Wolfe, the founder of Wolfe Investments who has been involved in over $91M in real estate transactions doesn’t like the complexity of the waterfall structure many syndicators use.
“We have steered clear of preferred returns mostly because those are usually accompanied with up-front fees charged to investors. Our investment structures are tied to the performance of the investment, and not just closing deals like the typical preferred return strategy.”
“If we make our investors money, then we’re rewarded. If we don’t then we aren’t rewarded.”
I originally didn’t plan to dive into the fee structure at all, but since Kenny brought up some great points, I think I’ll dive into the fees and how some different structures affect the incentives and performance of deals.
The Fees When Syndicating Real Estate
There are a lot of different types of fees used in syndication. Some are more common than others but all have their pros/cons. Here are the most common ones
I’ve seen this anywhere from 0 to 5 points with 2 being the most common. Acquisition fees in a syndication are really common and most have them, but not all.
Syndicators are running a business and that has costs. Acquisition fees help pay for the operating costs, staff, flights, hotels, diligence, and other costs that are needed to run the business.
On the other hand, acquisition fees can be enormous on large deals and can drive some deal sponsors to be short-sighted and focus on closing deals rather than operating deals profitably.
Think about it, a $10M deal with 2 point acquisition fee is $200,000. That adds up fast! You can see how some sponsors will lose track of buying good deals and focus on just closing deals, regardless of how good they are.
Asset Management Fee
This generally ranges from 1-3% of gross rent revenue. This may or may not go to the deal sponsor and it goes to cover the cost of managing the asset and management team that was hired.
Since the syndicator only gets paid when the asset is cash flowing, there isn’t much incentive to take on difficult projects. That’s where the construction fee comes in. If there is a major rehab project a fee can be imposed to compensate the project manager while the asset isn’t producing income.
It can vary but is often 1-2% of the construction cost.
There are a lot of competing interests in a deal and it’s difficult to align everyone 100% of the time – that’s why trust must be built with anyone that you’re investing with.
But, a few major points to consider are how all the fees and the preferred return and waterfall all fit together.
Deals with high preferred returns and high fees create incentives for the sponsor to find and close deals, but not a lot of incentive to maximize cash flow. As Andrew pointed out, deals with huge benefits to the sponsor at certain levels can cause them to sell early to bump the IRR artificially and trigger that waterfall distribution.
But, deals that compensate the sponsor more will create more incentive to produce high returns.
That’s why there are so many different ways to structure deals! Every sponsor and investor pool is different so they can create deals that work for everyone.
Structuring a Syndication Deal – Example
Similar to how Andrew structures deals, let’s say that in this deal there will be an 8% preferred return, 70/30 split thereafter, and have a 2 point acquisition fee and 2 point asset management fee.
The limited partners will get 70% of the returns after the 8% pref and the sponsor will get the other 30%. The sponsor will get 2 points up front and 2 percent of the gross revenue.
Example 2 – Syndication Structure
Kenny, on the other hand, keeps it simple. He might charge an 80/20 split with no acquisition fee, no waterfall, and no preferred return. The asset management fee is 2% as well in this example.
So, the limited partners get 80% of all the profits and the general partner gets 20%. If it does well everyone does well and if it does poorly everyone does poorly. There are very limited fees except for the asset management fee.
Example 3 – Hybrid Structure
Mark kind of does it a third way. He said he generally does the 80/20 split, but he does charge an acquisition fee and asset management fee but rarely does a preferred return.
The acquisition fee is more similar to Andrew but his split is more similar to Kenny.
It’s interesting to see how 3 different real estate syndicators have three entirely different ways to structure their deals.
How To Find Real Estate Deals to Syndicate?
These are large deals and you don’t typically see them on the MLS, so how exactly do you find deals for a syndication?
Well, three different deal sponsors had three different answers:
“Now that we’re established as a solid buyer we get off-market deals across the US. We look at the on-market deals as well. These days the off-market deals have been much more attractive.”– Kenny Wolfe
Andrew Campbell appears to have a more holistic view for finding deals.
“It’s a full-time job, and it all comes back to relationships. Meeting and networking with brokers, talking to owners, title agents, insurance providers, property managers. Leads can come from anywhere, and in this market, you want to make sure you can see as many properties as possible, and the earlier and more off-market/limited market they are the better.”
Mark Kenney has seemed to be extremely successful working directly with commercial real estate brokers.
“We generally work through brokers to finds deals.”
What About LoopNet for Commercial Real Estate Syndication?
I’ve known about LoopNet for a while, so I was curious about it. Kenney put it simply though:
“Loopnet is where deals go to die.”
But, David Eldridge of NAI Glickman Kovago & Jacobs, a commercial brokerage firm in Worcester, Massachusetts, said,
“Loopnet is far from dead. We do a ton of volume on it and use it almost exclusively for smaller listings.”
How Do You Find Commercial Brokers and Get Them to Take You Seriously?
Commercial brokers are dealing with a lot of big players in the market, and it can be difficult to get them to take you seriously if you are a new player.
Mark pointed out that “a market generally only has a few major names. The top 2 or 3 people have access to virtually all the deals, so you just need to identify them.”
He continued, “it’s not hard to get yourself onto their email list, but it can be more difficult to get people to take your offers seriously. It’s important to have some experience in the field and if you don’t, then partner up with someone who does have the experience.”
In the end, money talks and the highest offer usually wins. So, you can make up for experience with higher offers.
The Cost To Syndicate A Real Estate Deal
Now that we’ve got past the “what is a syndication in real estate” and the “how to syndicate in real estate” part of the article, we can get into the costs and money aspect.
The first logical question is about the cost of a syndication.
There are several major fixed cost items that every syndication requires, including – SEC attorney, earnest money deposit, diligence, private placement memorandum, loan application fees, and more.
So, let’s break them down. As some fees are percentage based, I’m going to create a hypothetical $2,000,000 deal.
- Attorney for Contract – $3,000
- SEC Attorney for PPM – $12,000
- EMD – 1% – $40,000
- Diligence – $25-$50 per door – $2,000
- Loan Application – 1% – $20,000
- Other Financing Costs – 0.5% – 1% – $20,000
Total Costs – $97,000 to get the deal done, of which $40,000 goes toward the purchase.
So the total fixed costs are $57,000 or 2.85% of the total deal price. As you can see, this is not cheap!
The syndicator has to front all the money and if the deal doesn’t close most of that money can be lost. So, you can see one reason why syndicators are compensated pretty well.
How Big Do Syndication Deals Need To Be?
We are talking some pretty big numbers here overall. Realistically though, how big or small does the syndication deal need to be in order for it to make sense?
Universally, all of the deal sponsors wanted to do larger rather than smaller deals. Both Mark and Kenny said they want deals over 80 units which allows for full-time on-site property management. Andrew prefers to look at it as a dollar figure and prefers to do deals over $8 million to keep the fixed costs as a small percent of the total costs.
How Do You Find Investors?
Most people reading this are probably wondering how you can find people to invest so much money. Most people can save up $50-100k, but you are talking about raising hundreds of thousands, or even millions of dollars for a deal. How?
Andrew says it’s a “second full-time job” which comes back to relationships and marketing. He does at least 5 sit-down meetings a week to grow those relationships.
Kenny is so well established that most of his new investors come from referrals though he also does a meetup, podcasts, and general outreach.
Example Syndication Deal
You might be wondering how much a syndicator can actually earn from one of these deals. So, I put together this example based on the knowledge I gained.
Let’s assume we found a property somewhere in Texas with a 6.5% capitalization rate. It’s about 70 units and is selling for $60,000 per unit. That’s $4.2M total.
A 6.5 cap rate means the property has a net operating income of about $273,000 per year before finance costs.
With about $875,000 as a down payment, that’s about $190,000/year in finance costs (I’m rounding).
So the cash flow is about $83,000/year.
Of course some of that goes toward principal, and eventually, the deal will be sold and that will get distributed back to the investors. For now, though, let’s just focus on cash flow and not the entire return.
What The General And Limited Partners Earn In A Syndication
I’m going to keep the numbers super simple so I can do it all in my head. Let’s take the 1% asset management fee out of the gross rents. We don’t have a number for gross rent (only NOI). Let’s say it’s $8,000. If you were the asset manager, great you get to pocket that. If not, someone else does.
The rental income is now $75,000.
Of that cash flow, let’s say the syndicator is doing a 90/10 split and will earn 10%.
And let’s say he also put in about $100,000 into the deal, they would have a total equity of 21.4% and would get about $16,050 in cash flow. That’s about a 16% cash on cash return for the principal (excluding the asset management fee). Don’t forget, they earn the same returns as other LPs on the cash they invest, and then get their split just for doing the deal.
Realistically, this example doesn’t include any growth in value and is a very simple example.
Now You Know The Basics
…and it’s time to download your deal calculator to help you start analyzing your next deal.