The Pros and Cons of investing in real estate syndication
Alina Trigub2020-12-27T01:04:07+00:00The Pros and Cons of Investing in Real Estate Syndication
When considering any significant decision, many of us defer to a “pros” and “cons” list. Why? It is our best attempt to objectively determine whether we perceive something as “good” or “bad” based on the sum of smaller, individual points. When it comes to investing in syndications, a pros and cons list is a great starting point, especially since investors tend to have varying degrees of experience, knowledge, and risk tolerance.
We have all heard that “no risk equals no reward,” so it’s no wonder that apprehension, and sometimes fear, silently accompany an investor into a deal.
Although we are hard-wired to fear threatening situations, fear can take on a life of its own, especially for the new and less experienced investor who is considering his or her first deal. On the other hand, savvy investors understand that while every investment contains some risk, they instead seek to understand whether the benefits outweigh the risks, and how they may be able to maximize profits while mitigating potential risks.
Below are some of the main pros and cons associated with syndication investing. Prior to outlining the pros and cons, let’s define a syndication. A real estate syndication is a mean for multiple investors to pull the funds together to invest in a large commercial real estate. A sponsor (aka General Partner) often has some amount of money in the deal, but is primarily contributing his or her knowledge and experience, while the investors (aka Limited Partners) finance the deal in exchange for a return on their investments.
Pros of Investing in Syndications
- Hands off (Passive)
Syndications are one of the truly passive investments in today’s real estate market. While it’s in the investor’s best interest to thoroughly evaluate the sponsor and their deal, their primary role is to provide a financial contribution. The amount of money invested ranges depending on the size of the deal, but once the money has changed hands, the investor’s responsibility is to trust in the sponsor and patiently await to collect the returns on their investment.
- Passive and residual income
Syndication deals are designed to provide financial returns to investors on a regular basis once a property becomes profitable. Investors first generate passive income through a preferred return, which is generally a percentage of the initial investment. For example, an investment of $50,000 in a deal with an 8% annual preferred return may potentially yield $4,000 per year. Typically, after the investors have received their preferred returns, any remaining profits are then split between the sponsor and investors according to a split outlined in the deal. For example, an 80/20 split would yield 80% of remaining profits to investors and 20% to its sponsor. Equity investors also have the ability to capitalize on income at the time the property is sold. The returns, split, and timeline are specific to each deal, but residual income is one of the biggest drivers for investors to participate in a syndication.
- Tax benefits
The primary goal of real estate investing is to create positive cash flow and utilizing creative tax strategies. It allows investors to take home a greater share of their income. There are multiple tax benefits that apply to syndication deals, many of which are related to depreciation: the decrease in property value based on normal wear and tear. (To clarify, depreciation is an accounting expense but does not represent that the value of a property is actually decreasing.) For example, a commercial apartment building valued at $2,000,000 can write off over $51,000 of depreciation annually when applying straight-line depreciation. While subtracting depreciation is a common tax strategy, a typical commercial building life is spread out over 39 years.
Most syndications do not last for so long, sponsors will sometimes accelerate the depreciation in order to show a greater amount of loss over a shorter period of time by leveraging another tax saving strategy called cost segregation. Because cost segregation requires additional expertise at an additional expense, is not implemented in every deal and should be discussed at the outset of the deal.
Another major tax benefit enjoyed by syndication investors is that they do not pay taxes on return of capital when cash out refinance strategy has been implemented.
It is also important to note that profits received at the time a property is sold are taxable, but can be avoided if applied to a 1031 exchange in the sponsor’s next deal.
- Capital preservation
As its name suggests, capital preservation is a conservative investment strategy aimed at preserving capital while minimizing, and ideally, avoiding losses. Capital preservation strategies are closely associated with short-term investment making syndications prime candidates for capital preservation. It is typical for syndication investors to earn an 8-10% rate of Cash On Cash return (COC) over a relatively short period of time (i.e. 5-10 years). Though the stock market boasts a similar return of around 7%, the average should only be considered for long-term investments of at least ten years due to the stock market’s volatility.
- Calculated risk (relative to other investments)
The ability to calculate risk plays a large role in an investor’s analysis of an investment. Thankfully, syndication risk can be reasonably correlated with the sponsor’s experience, the market, and the offering itself. The more experienced the sponsor, the more likely he or she will successfully execute the deal. Since syndications often involve a large group of investors, risk is spread out among the group instead of one or two individuals, mitigating potential individual losses.
Cons of Investing via Syndications
- Lack of control
A crucial component to understand prior to investing in a syndication is the lack of control investors have once an investment relationship begins. An investor’s control is limited to their choice to work with a particular sponsor; investors are not involved in the deal, day-to-day operations, or decision-making. In fact, the best investors are those who remain interested yet understand their role and respect the boundaries and relationship with the sponsor. Conversely, the investor who is constantly badgering a sponsor about the deal’s progress will gain no additional control in the process and may even hinder the sponsor’s effectiveness. While the lack of control can be a “pro” for some, it can be a significant downside for others.
- Lack of liquidity
While participating in a syndication, investors are legally bound to the deal and investments are not illiquid until the property is sold and profits have been distributed. An investor who needs to exit a syndication early should reach out to a deal sponsor to ask for a potential loan or to negotiate a deal, but even if it will be possible to arrange selling your securities back it may happen at a discount. Due to the lack of liquidity, it is not wise to invest a significant portion of one’s cash into a deal.
- Holding time
Depending on your investment strategy and market conditions, the typical length of a syndication deal can be a drawback for some. While the sponsor will share an anticipated timeline with investors at the outset, external factors and unforeseen circumstances can impact the accuracy of the deal’s timeline. For example, a sponsor who plans to buy and hold an apartment building for five years could be prevented from selling at the target price due to market conditions. If it ultimately takes seven years to sell the property and for investors to recoup their investment, it can be stressful if an investor was banking (no pun intended) on using that money for another investment or expense.
The pros and cons of syndication investing are not limited to those mentioned above but should simply be used as a guidance when evaluating an offering. Investors may not be afforded much control when investing via syndication, but investors who are better prepared will be able to make capable decisions whether to invest in a deal. The combination of financial benefits and the ability to predict investment security based on the sponsor’s track record make syndications an attractive vehicle for investors with a wide array of financial objectives and risk tolerances.
