By now hopefully you’ve read “Intro to Group Investment in Real Estate” and have additional interest. By now you are likely wondering how it is actually structured, how you make your money, and when. Be sure to read on to “Participating in a Group Investment” as well.
Every group investment (Syndication) is structured a bit differently. How profits, losses and management are handled is always determined and agreed to before the group is ever formed, so be sure to read the Private Placement Memorandum (PPM - basically a business plan for the property) and operating agreement of the Syndication to fully understand the specific opportunity being offered. However, below is the most typical way everything is set up. For this example we will assume the group is investing in a specific property instead of an opportunity fund where only the criteria of what the group will invest in is known.
Corporate Structure
The investment property being purchased is not typically held in the individual names of those in the group but held in the name of some form of corporation or trust. The individual investors own the interests of that corporation. There are several corporation statuses that can be chosen, but for all intensive purposes, the most common structure is that of a Limited Liability Company (LLC) as it offers limited liability to investors, as well as being treated as a pass-through entity for taxes. Meaning the profits of the company are NOT taxed, then whatever is left over distributed to investors, which is again taxed on the individuals tax return (double taxation). With the LLC the deductions, losses, and profits are passed straight through to the investor’s individual tax statement.
Minimum Investment
A property has been found by the group’s sponsor, it is under contract, and due diligence has been completed; you have reviewed the PPM and determined you would like to be a part of the investment. To participate with the group there is almost always a minimum investment with the ability to invest in any specified increment above that as the investor desires. The total amount one invests determines the percentage ownership in the group they have.
Example: A group needs to raise $1,000,000 to purchase and renovate a property. The sponsor sets the minimum investment in the group at $50,000 with additional units in the syndication available in increments of $1,000. In this case, an investor can simply put in the minimum of $50,000 or could put in $72,000, really any amount to the nearest thousand above $50,000.
Minimum (Preferred) Return
Not all Syndications have a provision like this, but the one’s I would invest in would. As mentioned in the Intro the sponsor of the group is basically the CEO of the investment, and they share in the profits as incentive to make as much profit as possible for the group. However, I personally think it is best to set a minimum standard for the sponsor to further ensure they don’t get complacent with mediocre or underperforming returns. This is where a minimum (technical word is preferred) return comes into play. It sets the minimum returns the investors will receive before the sponsor can participate in any of the profits….then not only does the sponsor not make money unless the investors make money, but they don’t make money unless the investors make at least a minimum return on their money. This preferred return is typically a negotiation between the sponsor and the investor, and based on the potential a particular property may provide. Preferred returns are typically between 5% and 8% for smaller syndications. There are NO MAXIMUMS however, if the property ends up yielding 50%+ over time, the investor will collect their entire share of the profits.
Example: An investor has put in $100,000 in a group investment. The group has a set the preferred return at 6% annually. So before any profits are split with a sponsor, that investor must receive a $6,000 profit, and not only does the sponsor not make any money if this minimum return isn’t met, but if there is a shortfall in the early years (which can be common on some properties that require a repositioning), that short fall is added to the next years minimum return. So over a 10 year investment lifetime, the minimum an investor should receive would be $60,000 in profit.
Percentage Ownership
An investor’s ownership stake in the property will be determined by the total percentage of their investment divided by the total amount of funds raised in the syndication.
Example: An investor has put in $100,000 of a total $1,000,000 group investment. That investor owns 10% of the Syndications LLC and is entitled to 10% of the profits, 10% of the tax deductions, and 10% of the capital gains due the investors in the group.
Sponsor Profit Share
The better Syndications have a preferred return to investors; the amount of profit generated over this return however, is split with the group’s sponsor. It is their compensation for finding, evaluating and managing the property on behalf of the group. These splits are typically between a 70/30 (70% of profits to investors, 30% to the sponsor) up to 50/50 or more. The split can be further segregated to profits generated out of on-going cash flow, and capital gain when the property sells for a profit; and may not be the same split for each. Generally, the better the deal the sponsor finds, the higher the profit split will be.
Example: A sponsor has put together a $1,000,000 syndication with a 6% preferred rate of return. The investment is doing well however, and this year there are $100,000 in profits. $60,000 of those profits goes straight to the investors to satisfy the preferred rate, but the remaining $40,000 is subject to a 70/30 split with the sponsor. This leaves an additional $28,000 due to investors (a total of $88,000), while the remaining $12,000 is the sponsors compensation for a successful year.
In the next year, after much effort by the sponsor to renovate and fill the property with tenants, the investment has greatly increased in value and is sold. The total cash left after the sale is $2,000,000. $1,000,000 is returned to the investors as their original investment and the extra $1,000,000 in profit will be split between the investors and the sponsor. At a 50/50 split (this property required much more effort and skill to renovate and lease up than a more simple property, so the split is higher for the increase in value attributed to the sponsor’s effort) $500,000 would be due the investors and $500,000 due the sponsor.
Lifetime of the Syndication (Exit Strategy)
A purchase of an interest in a Syndication is not liquid. In fact most of the time Securities and Exchange Commission rules prohibit anyone from selling their interest for at LEAST one full year. Add to that there is a very limited pool of buyers that would be interested or able to purchase your ownership interest, and the possibility of being able to liquidate your investment becomes difficult. This is why the Private Placement Memorandum (PPM) will outline exactly how long the group’s lifetime is, specifying under what conditions the sale or refinance of the property will happen and/or setting a specific time period the property must be liquidated by. Typically an investment of this sort will be a minimum of 5 to 10 years, usually with provisions to extend every 1-2 years by vote depending on what the investors and sponsor believe is best for the investment.
There usually are provisions that will allow early withdrawal with limitations. Limitations typical are the ability to only withdrawal during a certain window of time each year, the requirement to first offer the ownership to other owners in the group and the sponsor based on a current valuation of the property and its income, and typically a fee to arrange for the transfer. So it is possible, if the need of the investor is dire enough, but in general, only invest with a group with funds you know you will not need access to for the lifetime of the Syndication.
Comments(1)