The Basics of Commercial Real Estate Syndication: What is it and how can you benefit from it?

After two decades working in venture capital and real estate investment and development, I am convinced that commercial real estate syndication is one of the most effective ways for investors to achieve passive income. It has become a key investment strategy, both for my business and my personal investing portfolio. Let me tell you about it.

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First, what is a Commercial Real Estate Syndication?

In simple terms, #realestatesyndication is a legal structure that allows a group of private investors to pool their financial and intellectual resources to purchase and manage larger investment properties than they would be able to tackle on their own. And it is my top recommendation for people looking to break into commercial real estate investing.

If you're familiar with crowdfunding sites like Kickstarter and GoFundMe, you already understand the basics of real estate syndication. None of us could launch a multi-million dollar virtual reality headset company like Oculus on our own, but a group of 10,000 investors on Kickstarter pooled their resources and did just that in 2012. Two years later, this Kickstarter-launched business sold to Facebook for $2 billion. Investors willing to combine their financial resources can create more income and wealth than individual investors can achieve on their own.

In the same way, when investors are considering moving their funds into commercial real estate, a real estate syndication provides the same investment vehicle, giving individual investors access to much larger investment opportunities than they would be able to secure with their own resources and expertise.

A real estate syndication has two major players:

• The Sponsor (also called General Partner)
• The Investors (also called Limited Partners or Passive Investors)

?As their titles suggest, the sponsor is the point person on the project - they put in the sweat equity to find the investment, develop a business plan, run due diligence on the deal, raise capital for the project and then manage the day-to-day operations. The sponsor generally has subject matter expertise in real estate development, property management and structuring real estate syndication deals.

The investor's role in the syndication includes evaluating the sponsor's proposal and then providing capital. Investors act as silent investors, with no day-to-day responsibilities for the investment management.

Sounds like a pretty sweet deal, right? Let's dig a little deeper and decide if this is the right investment opportunity for you.

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Pros and Cons of Commercial Real Estate Syndication for Investors

Pros / Benefits for Investors:

I'm a huge fan of commercial real estate syndication - both as a sponsor and for the individual investors. Here's my top reasons why:

• Access to larger projects and assets for individual investors
• Opportunities for new real estate investors to learn the business without all of the downside risk of managing the day-to-day operations
• Truly passive real estate investing and cash flow for investors
• The same benefits as single-family real estate investing, such as forced appreciation, passive income tax bracket and depreciation.

?I have found commercial syndication to be a great starting point for new real estate investors, and an ideal path for experienced single-family investors to transition to larger deals in the commercial real estate world with fully passive income.

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Cons / Risks to Investors:

No investment comes without risk. Some of the risks associated with commercial property syndication include:

• Budget overruns that lead to capital calls - due to mismanagement or uncontrollables like inflation in construction costs
• Project delays due to permitting / red tape or weather delays
• Increased rental rates lead to short term vacancies
• While rare, the bank can call a loan, requiring immediate payment in full
• Mismanagement by the general partner

?It’s critical for individual investors to carefully consider their own risk tolerance and have a frank discussion with the syndication sponsor about the likelihood of each of these risks, and what strategies are being implemented by the sponsor to mitigate the risks.

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Real World Example of Commercial Real Estate Syndication

I recently managed my own syndication, and it’s a great example of how this investment structure can benefit everyone involved. For the project, I partnered? with several commercial real estate pros and a group of new investors. This was an independent project for me and a handful of partners. We assembled a diverse group of investors and sponsors to make this real estate syndication a big success.?

This group developed a 12,000-square-foot building project in downtown Chattanooga from the ground up. It’s now home to Slim & Husky’s first location in Chattanooga, and the future headquarters of the Urban League of Greater Chattanooga. Our group not only completed the development, but also recruited the tenants and buyer of the building.?

We launched the syndication project in March 2020. If you remember what the world looked like in March of 2020, you already know this was not an easy project. Try getting a project loan during the first few weeks of a global pandemic! We had to shift our strategy, and our construction timeline was slowed due to the many impacts of COVID.? But our team kept working,? and just a few months ago, we sold the completed building for $3.8 million.?

While we earned significant returns for all the passive investors, the construction schedule was longer than expected due to factors well outside of our control. This is a great example of why real estate syndication isn’t the right fit for every investor.? Evaluating risk tolerance is critical - investors with a low risk tolerance would have been shaken by the idea of moving forward with a development project at such an unstable time. And if investors want to cash out by a certain date, real estate syndication might not be for them. Flexibility and risk tolerance are key.

As the syndicator on the downtown Chattanooga project, I was required to invest a portion of my own money in the project, as well as contribute sweat equity in managing the project and equity capital. This helped us secure our loan, and was also essential to the integrity of the project. As one of the project leads, I also benefited from the asset management fee, over the two years it took to buy, develop, and then sell the property. While I can’t disclose the investors’ exit numbers, I can tell you that we greatly outperformed the market - despite the fact that the stock market was incredibly successful in 2021 and early 2022.?

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Frequently Asked Questions Re: Real Estate Syndication Opportunities

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Do investors receive a guaranteed return on investment?

While I consider commercial real estate syndication investing to be a winning strategy, it is not without risk. Any honest sponsor or general partner will tell you there is no guarantee for your return on investment. If someone is promising a guaranteed ROI, run away.

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How long before the investors see a return on their investment?

The timeline is dependent on the business plan and the deal structure. Most syndications will identify a three to five year exit strategy. So investors will receive cash flow from the investment for the life of the project, then receive a final payout once the property sells, and the syndication closes. Be sure to discuss the specifics of the timeline and exit strategy with your commercial real estate syndication sponsor.

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What are the tax benefits of investing in a syndication?

Just like buying a rental property in your own neighborhood, larger-scale commercial real estate syndication investing brings a host of tax benefits, including;

• passive income investments are taxed at an advantageous rate
• depreciation and expenses provide tax shelter for income
• using IRA funds to invest in real estate assets provides additional tax shelter opportunities

As always, consult with your CPA to verify current regulations and their impact on your individual tax liabilities.

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How does the ROI compare to investing in residential rental properties on my own?

Many real estate investors get their start investing in single-family homes in their own neighborhoods and communities, which is a great opportunity for a new investor to learn about the real estate market. The upside potential may be a little higher if you are managing the rentals on your own, without a property management team. But that can be time-consuming. This type of rental property investment also creates downside risk for individual investors, who take on maintenance and capital improvement costs on their own. Replacing one HVAC unit or roof repair and you've lost all of your potential profits for a year or more.

Commercial syndication provides a potentially lower initial cash flow, but generally higher payout at exit, due to forced appreciation. Investors also escape the burden and liability of the day-to-day management of the rental property.

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How do real estate investors profit in a syndication?

As mostly silent investors in the commercial real estate investment, limited partners receive returns based on their equity participation in the real estate project. Most syndicates will pay a preferred return to investors, before the sponsor. So, hypothetically, if the deal structure outlines a 9% return to investors, the sponsor receives their return on investment only after the investors have received their 9% ROI.

The equity participation has two major components - cash flow (based on rental income, usually paid quarterly), and the payout once the property is sold and the deal is closed. Investors should expect both income streams to be structured as percentage splits of income to the investors and the general partner.

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How do the real estate syndicators / sponsors profit in a syndication?

Most syndicators are required to invest a portion of their own money in the project, so their investment is both sweat equity and equity capital, as opposed to the investors or limited partners, who generally just invest money. As such, the earnings percentage for the general partner are greater than the silent partners. Potential sponsor fees include:

Acquisition fee - this fee covers the time and expense associated with identifying the property, performing due diligence and structuring the purchase and the syndication. The acquisition fee can be a fixed price, or a percentage commission on the total project cost, typically between 1-4% of the cost.

Asset management fees - while the acquisition fee covers the time and expense of upfront costs for the syndication, asset management fees cover the ongoing time and expenses for managing the property, including overseeing the day-to-day operations of the property manager, keeping all of the limited partners informed on progress and overseeing legal and tax preparation for the investment. This fee typically ranges from 1%-5% of monthly gross revenue.

Equity participation - this is the same category of income that the investors receive - a cut of the cash flow based on equity investment. The sponsor's percentage is also dependent on the expertise they contribute to the project. Percentages paid to the general partner can vary widely - between 5-50% of total cash flow.

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The bottom line...

Commercial real estate syndication offers unique opportunities to launch a real estate investing portfolio or diversify an established portfolio into larger real estate deals with greater wealth-building potential. It is one of my secret weapons for building my own investment portfolio, and I'd love to help you decide if it's the right next step for you. For more information or to download my evaluation worksheet, visit me here.