The way syndication works generally is that one party will have experience with operations of a project, whether it’s running a restaurant or a condominium community, and the other party will invest financial equity. Both parties will earn on profits depending on how much time and money they’ve invested. The sponsor is the party responsible for scouting property, managing day-to-day operations, and raising funds for the project, while the investors simply provide funding. The tasks that the sponsor has to accomplish to get the project off the ground are crucial to its success, and investors usually have to rely on the sponsors knowledge. The non-monetary effort, labor, and expertise of the sponsor is called sweat equity.
A typical financial split in a real estate syndication will be that the sponsor will be responsible for contributing between 5% and 20% of the total needed to purchase a property, while the investors will contribute up to 95%. Within a limited liability company or limited partnership, the investor will be considered a passive partner while a sponsor will be a general manager.
There are actually several ways that a real estate syndication can be set up.
The first is through a corporation. Setting up a corporation lets the partnership become its own entity, which means that it has responsibilities and right just alike an individual in terms of law and will be consider to be a ‘legal person’ relative to its owners.
The second is a Limited Partnership. An LP is usually formed by at least two partners in business, although one may be liable for less than the other. Their liability will depend on the amount of their financial investment. In LP, partners receive profit from direct access to income from the investment, like rent, instead of dividends.
The third is a Limited Liability Company, or an LLC. This is a combination of a limited liability company and a corporation. In an LLC, the owners can’t be held responsible for the debt of the company. The owners, both the investors and the sponsor, will be protected against disputes as well. Setting up an LLC is the best way to ensure that both parties are protected against any disputes. An LLC or LP partnership agreement will resolve issues like rights to distribution, the sponsor’s rights to be reimbursed for running the property, voting rights, etc.
Profits usually come through rentals in real estate syndication, as well as properties naturally gaining value over time with good upkeep. Rent income is passed to the investors by the sponsor based on the schedule outlined in the LLC agreement. This can mean either quarterly or monthly. Sometimes it can take as long as 10 years for a property to start making profit, while others take as little as 6 months. Appreciation will be affected by the management style, state of the market, location, and other factors. Before the sponsor receives any of his or her profit for work performed, the investors will get a preferred return, which is usually 5-10% of the funds invested initially. This is considered to be a benchmark payment.
Depending on the agreement, there a few ways for sponsor to earn on running a real estate property; not just through rent. They include the following:
– Acquisition fees: Finding and operating a property involves work. Sponsors will perform due diligence, as well as having a hand in structuring the contracts. Acquisition fees can range anywhere from 1%-5% of the cost of acquisition, or sponsors can choose to charge a flat fee, like $25,000. Generally, investors will be willing to negotiate price points, although if a sponsor chooses to charge too highly, investors may be wary of working with them. A balance for fairness must be met.
– Asset Management Fees: Asset management fees tend to be about 1% of total income, or gross revenue. The sponsor receives this fee because they not only manages the property but also the syndicate. That entails regular communication with investors with updates about their investments, as well as making sure investors are receiving compensation based on the schedule outlined in the agreement. Property management entails staying in communication with the manager of the property, as well as tasks like overseeing renovations when needed and making sure they’re completed to a high standard and preferably for less than the intended budget.
– Equity Participation: A sponsor’s contribution to a property investment can range anywhere from 5%-50%. Generally investors will receive a preferred return rate of about 8%-12% because they’ve usually invested more than the sponsor. The remaining equity and income will be divided amongst the sponsor and the other investors according to the split arrangement outline in the LLC.
An example of a real estate syndication would look as follows:
A group of investors decide to put down one million dollars on a building in cash, and have no mortgage responsibilities. The investors contribute the entire amount and cover the acquisition fee, which is included in the building fee. The building starts to bring in income at a rate of $120,000 per year, and the investors get their interest payment first at 8%. This means investors get $80,000 out of $120,000 of that first year, which is 8% of one million dollars. The rest, which would be $40,000, would be split between the sponsor and the investors at the rate previously agreed upon in the LLC, let’s say 50/50. This means that investors walk away with $80,000 from interest along with $20,000 from the remaining split in equity. This means investors get a 10% cash on cash return, and because they also have equity, their earning potential appreciates as does the value of the property. Selling or refinancing the property would also be income for investors.
The sponsor has the benefit of being able to participate in the deal without having to invest a lot of capital. He or she also would have gotten paid an asset management fee, an acquisition fee, and an additional $20,000 in the contractual split. On top of that the sponsor would have a 50% stake in future value appreciation of the building.
Before the use of the internet, the only way that syndication was carried out was through a network of investors. This was done to ensure that the deals they were investing in were trustworthy and would be likely to bring profit. Now, with the rise of crowdfunding and internet use. It’s easier for people to get funded due to crowdfunding, which is a process in which people put together a project and open the project to as many investors as they like. If the project gets funded, it goes ahead, if not, then the funding is returned to investors. Crowdfunding allows anyone to get involved, because there are lower investment minimums. Because the information is open, there’s more of it available as well.