Real Estate Syndication

Foreword

I’ve received, over time, numerous requests from various people inquiring about real estate syndication. Here is a quick summary of the space, and the things I look out for when evaluating a new deal.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Real Estate Syndication

As way of a quick introduction, real estate syndication is a fancy way of saying a “real estate fund”, or, in some cases, “real estate private equity fund”. The former (real estate fund) is more general, and encompasses various real estate strategies (explained below), while “real estate private equity fund” refers specifically to funds which buy properties, improve them somehow, and then sell them again — Similar to how generic private equity funds buy companies, improve their operations, and then sell the companies again either on the private or public markets.

Terminologies

Before we dive in, here are some common terms which will come up over and over again in this space.

Sponsor, General Partner, GP	The people who found the deal and are marketing it are generally called the sponsor. The people who actually run the day to day operations as well as make major decisions on behalf of all the other investors are called the general partner (or GP for short). In general, the sponsor will usually be the GP, so the terms are used interchangeably in most cases.
Broker	The people/entity which is purely marketing the deal on behalf of the sponsor. The broker typically takes a cut of the profits, either in the form of a front load (a fee up front as a percentage of committed dollars they bring in) and/or an equity stake (usually a percentage of the profits). While brokers are common for really large deals (hundreds of millions to billions of dollars), they are uncommon for smaller deals (under $100m). Personally, if a smaller deal has a broker (or worse, many brokers), I would consider it a sign that the sponsor is new to the game and simply doesn’t have a large enough rolodex of investors to call upon. Some common brokers are FundRise, CrowdStreet, YieldStreet, etc.
Investor, limited partner, LP	The people who actually put money into the deal. While the GP earns their profits from sweat labor, the LP earns their profits from equity labor, i.e. actual return on actual cash put into the deal. In particular, the LP is also limited in that they have no say in the day to day running of the deal. This is important! A key determination of who has limited liability (and thus can walk away from a failed deal by “only” losing their investment) vs who has unlimited liability (and thus may be personally liable for any losses/debts) is who is responsible for making decisions and who actually made decisions. Before you take part in any deal, make sure that you are joining as an LP, unless you are comfortable making decisions for the deal, and taking responsibilities for the consequences of your decisions.
Capitalization rate, cap rate	The capitalization rate of the deal. At the start of the deal, this is obviously estimated, but when a deal exits (sells of its assets), the “exit cap rate” is also of interest and is typically actual (instead of estimated). Cap rate is simply the “net operating income” divided by the value of the asset. In a hand-wavy sort of way, you can think of it as the inverse of the P/E ratio that is so common for stocks.
Internal rate of return, IRR	The imputed return of the deal (either estimated or actual, depending on context) over a period of time, annualized to one year. The IRR is more complicated than simply the return of the deal divided by the amount invested — the timing of the return of capital and profits is important! A deal that takes in $100, and then immediately returns $100 the next day, while also returning another $100 over the next year, is a much better deal than one that takes in $100 and returns $200 at the end of the next year. Both deals return $200 over a one year period, but the former returns your capital almost immediately, letting you put that capital to further use. Think of it this way — assuming you can and do put all cash thrown off by the deal back into the deal and compounding at the same rate, then 2 deals with the same IRR and same period of compounding will return exactly the same amount of money at the end of both deals.
Levered returns, levered IRR	Almost all real estate funds use leverage, because without leverage (and the associated risks!), most real estate deals simply do not make sense — you can get much better returns with much lower risks by just investing in the stock markets passively. Levered returns or levered IRR is simply the actual (or estimated, depending on context) return or IRR after including the multiplicative effects of leverage and taking out the costs of leverage (i.e. interest fees).
Gross return, gross IRR, fund level return, fund level IRR	“Gross” basically just means “fund level” in this context, which means whatever number listed, is for the fund before the GP takes their cut, but after all other applicable fees, such as property management, expenses reimbursements, legal fees, etc. While these numbers are interesting, the more important numbers are the “net” ones. Always be sure to ask the GP for the net numbers, and if you have both net and gross numbers, then you can get a sense of how much the GP is getting paid.
Net return, net IRR, investor level return, LP level return, investor level IRR, LP level IRR	“Net” basically just means “LP level” in this context, so the number listed is the actual (or estimated, depending on the context) return that you, as the LP, will get. These are the numbers you want to use when comparing two otherwise equal deals.

Strategies

There are 4 main strategies for real estate funds:

Development	This is where the fund takes in capital to build a new property. There are two exits: a) The property is sold to buy/hold investors. b) The property is converted into a buy/hold investment for long term holding. In some cases, a fund may even opt for both — the property is sold to an affiliated buy/hold fund, and existing investors can opt to collect cash of the proceeds, or to roll over their investment into the new buy/hold fund. If too many investors opt to collect cash, then investors rolling over may be given the opportunity of putting in more cash, or the GP may find new investors or even put in their own money to make up the shortfall. In general, development funds are the most risky, as a lot of things can go wrong during construction, and delays, additional costs, etc. are common. Also, during the period of construction, there is no cash flow — the property is not in a rentable state! As a result, a successful development deal tends to have the highest returns.
BRRR(R)R – Buy, Rehab, Rent, (Refinance), Repeat	This is a strategy popularized by some influencers, such as the founder of BiggerPockets.com. The basic idea is to a) Buy a piece of property that is somehow mismanaged, either because management has let it fall into disrepair, the property isn’t positioning it properly for the local market, etc., b) Rehab the property by fixing the issues identified, either by fixing whatever’s broken, or renovating the property to position it as more upscale, etc., c) Rent out the property with the fixes in place for higher than what it was previously rented for, d) (Optionally) Refinance the property at the new, higher, valuation to take cash out of the deal, e) Repeat the entire process. Generally speaking, if the goal is to sell off the property to recapture capital invested, then the refinance step may be skipped and instead the property is sold off. This is the “real estate private equity” strategy. If the goal is to keep the property as a long term profit generating asset, then refinancing may be a good way to get some (or in some cases all) of the invested capital back so that it can be put to use in a new deal. In general, this strategy is less risky than development, but more risky than buy/hold. As a result, it tends to have returns in between the other 2 strategies.
Buy/hold	This is the simplest strategy where the deal is to simply buy some property at some perceived fair price, and the GP is in charge of handling the day to day operations of the property, while returning a portion of the rental income to LPs as dividends. In general, this strategy is the least risky of the 3, but as a result, also has the lowest returns.
Opportunistic	This is a catch all phrase for “everything else”. In these types of funds, the sponsor has a lot more leeway to do whatever they deem is appropriate, which can be good (if the sponsor is good) or bad (if the sponsor is not). Be sure to read the incorporation documents to know exactly what the sponsor is allowed or not allowed to do, and make sure you are comfortable with everything listed before you sign your name!

Evaluating a deal

When I evaluate a deal, I look at 2 main things:

• The sponsor
• The deal itself

Sponsor

In the case of the sponsor, the things I look out for are:

Is the sponsor trustworthy?

Anyone can put up a website and ask for money. Anyone can claim 10, 20, 30% IRR.

Doesn’t mean they mean it or that they can do it.

There are lots of unscrupulous sponsors who put up misleading and/or outright faked information to get investors, and I’m not particularly interested in investing with them.

Does the sponsor have the experience to bring the deal full cycle?

Even if the sponsor is acting in good faith, they may simply be too inexperienced to handle the deal and the stresses involved. If everything goes well, this may not matter, but if something breaks, I’d like to know that the sponsor has seen similar situations before, and/or at least have a vague idea how to handle the setback, instead of just throwing their hands up in the air and possibly sobbing in the corner.

Evaluating the sponsor

One of the best ways to evaluate if the sponsor meets both criteria, is to see what their track record is — if they have been running the company behind the fund for at least 8-10 years (roughly the time it takes to bring a fund full cycle, or at least 4-5 individual deals), and they’ve done so without changing their name (personal and company), then that’s a good sign that:

• They have been successful enough that they aren’t sleeping on the streets.
• They have built up enough of a reputation/goodwill that they are unlikely to throw it all away just to scam lil’ ol’ me.
• They have been doing this for a while, so they are at least somewhat experienced and are not flying in the dark.

Now, this isn’t a hard and fast rule — some sponsors worked for other funds, and are just starting out on their own.  If they were reasonably successful before, and they are just starting out because of ambitions (as opposed to, say, embezzling from the prior fund), then that’s a good sign too — while the fund itself doesn’t carry much reputation/goodwill, the sponsor themselves might.

I’m also not entirely opposed to working with new teams, as long as they show they know what they are doing — I’ll have to talk to them more.  But the point is that new teams tend to make mistakes, and I’m not particularly inclined to foot their tuition bill.

The absolute worst case is the “serial founder”, who creates new companies (not deals) every 5-6 years, and completely leaving out mentions of their prior endeavors.  This suggests that their prior attempts were less than stellar, and I’m not a fan of the deception, even if by omission.

There are other ways for sponsors to prove their mettle, such as being able to conduct a Q&A with ease and confidence, having a large social media presence for a long time (reputational risk if they mess up, also, if they did mess up, someone would have probably pointed it out, so you should look for those bad reviews), etc.

Another thing about sponsors — it’s usually about the team.  The more things that the sponsor does inhouse, the more likely they have control over their own destinies (and thus your investment).

If a sponsor is just a broker (i.e.: they seek investors, put the money in the fund, take a cut, then give the rest to another sponsor to do the actual deal), then understand that you are paying fees twice.  Once to the broker, and another time to the actual sponsor doing the work, whom you may never meet — because if you’ve met them, you may get the crazy idea that maybe, just maybe, you should cut out the middleman and make more for yourself.

Now, there are benefits to this arrangement — if you are deploying huge sums of money (say O($10m+)), then maybe it’s too much work to find all the deals yourself, and a broker is useful.  But if not…

BTW, and I may be wrong on this, but I believe that all such brokers need to be licensed (For example, https://dos.ny.gov/real-estate-broker for single deals. For funds, see SEC/FINRA rules).  If someone is clearly brokering a deal, and does not clearly list their licenses, then you should worry.

Deal

As for the fund, usually just understanding what the fund is doing will give you a good idea of what to expect. As discussed above there are generally a few types of funds:

• Buy/hold, sometimes called core/core+
• Buy and flip, sometimes called value add, or BRRR(R)R
• Build new, sometimes called development
• Whatever crazy scheme the sponsor can dream of, sometimes called opportunistic

Note: All numbers below are approximate for the period just before Covid19. For the 2 years after Covid19, real estate generally returned significantly higher numbers (a few multiples of the below in some cases) due to all the upheaval as people moved around. We’ll have to wait and see what post-Covid19 brings…

Now, if a fund is a buy/hold, then you’d expect levered net IRR to be in the 6-10% range, with cash flow generally steady from day 1.

For a buy/flip, you should generally see net IRR in the 12-15% range, though I’ve seen as high as 20-25% when the fund gets lucky. Cash flow in the first year is probably close to 0.  Cash flow in the 2nd year may be half of preferred (~4%), and then 8% in 3rd year, before 8-12% in the next 2-3 years.

Development funds can see net levered IRR be as high as 15-20%. Cash flow in the first 2-3 years will be 0.  No renter’s gonna pay you rent for an apartment that does not exist yet. So, if you come across a development fund, that promises 6% cash flow starting from the first year, you’ve gotta ask yourself this:

Where the hell are they getting the money in the first 1-3 years, while the property is being built, to pay me?

And the answer is, probably, they just took in more money than they really need, and are paying you with your own money. Which generally means:

• It’s a marketing gimmick.
• Actual net IRR is likely to suffer, since this additional money is non-productive, and just a paperwork transfer.

Location, location, location

Finally, for a deal to make sense, the strategy must fit the location.

• It doesn’t make sense to build class A+ buildings in a depressed neighborhood with median income in the $30k’s.
• It doesn’t make sense to do heavy renovations on a fund with many single family homes.
• It doesn’t make sense to build large apartment complexes in a city with heavy net outflow of households.
• It doesn’t make sense to value add a property that just recently underwent renovations.
• Etc.

Also, note that there are some states which are just extremely hostile for real estate investments, and a fund that tries too hard to make it work there, probably can make substantially more returns by just focusing their attention elsewhere. These states tend to have laws which make it hard to turn a profit on an investment, by severely restricting the landlord’s abilities to manage their property the way they see fit. For a discussion on this, see Affordable Housing.