Passive real estate investing part 2: Syndicated deals

As discussed in this post, one of the ways to invest in real estate without working on it full time is to put your money into a syndicated deal. Here’s how that works:

A syndicator is a professional investor who finds a property to buy and then arranges to obtain both the debt and the equity (the downpayment) from others. In exchange for his effort, he gets a piece of the profits.

Here’s how it works:

  1. The syndicator finds an appropriate property;
  2. He makes an offer which is accepted by the seller;
  3. He contacts the relevant banks and figures out how to get a loan on the property;
  4. He sets up an LLC to own the property;
  5. He solicits private investors to put up equity (cash for the downpayment) in exchange for ownership stakes in the LLC;
  6. Assuming he’s successful, the money comes in and the deal closes;
  7. The syndicator then manages the LLC and (if all goes well) upstreams the profits to the investors according to their ownership stakes.

Here’s how the investors typically get paid:

  1. A preferred return of somewhere between 6-9% / year on money invested. Initially, this is in the form of an “IOU” from the LLC. Once the cashflow starts coming in from the asset, it’s begins to be paid in cash;
  2. A portion of the profits on sale. Usually, the investors get 60-75% of the profits, with the syndicator taking the rest. For example: If you put up half the money in a 70-30 deal, you would get 50% x 70% = 35% of the profits.

Here’s how the syndicator gets paid:

  1. He often serves as the broker for the LLC buying the property and therefor receives the buy-side brokerage commission on the way in;
  2. He usually receives a series of fees from the LLC, including fees for acquiring the property, arranging the loan(s), and managing the asset (which usually means overseeing the management company that does the actual work). These fees come before the investors’ profits are determined.
  3. He often serves as the listing broker when the property is sold, thereby receiving the sell-side brokerage commission on the way out.
  4. He usually receives a share of the profits (see above) of between 25-40%, depending upon how the deal with the investors was structured. This share of the profits is paid only after the investors get their preferred return and their share of the profits.

Many investors seem to prefer syndicated deals to investing in funds, mostly because they can see the deal itself before deciding to invest. But there are a few reasons why I don’t love this model.

First, the fee model above does not allow syndicators to make a lot of money on each deal. Therefore, they make their money on volume by doing a large number of deals. That means they usually just pay whatever the asking price is in their preferred area, meaning that they accept whatever the “market” return is (since the return is a function of the relationship between cashflow and the price). If you want to just take the market return, you might as well buy the property yourself.

Second, sellers usually aren’t in love with the idea of doing deals with syndicators, because there’s no guarantee the syndicator will be able to come up with the money to close. Syndicators in effect say to sellers: “Let me tie up your property for 60 days while I try to raise the money to buy it”. Some sellers are ok with this, but only if they are receiving a very good price. So, almost by definition, syndicators are going to pay top dollar for assets, which is not a great recipe for high returns.

Despite the above, some investors just love these kinds of deals. So, as a practical matter, I am usually open to syndicating if the numbers make sense on a particular property.