[Editor's Note: This is part 4 in our real estate private placements series. Read parts 1-3 here. This particular post is a guest post by Jilliene Helman, the CEO of Realty Mogul, a company that helps connect investors with real estate private placement sponsors. We have no financial relationship.]
Investing in real estate as a passive investor can be a great option for investors who aren’t in a position to spend all their time searching for and then managing appropriate investment properties. For investors who do not want to deal with the hassles of tenants, toilets and trash, passive real estate investing gives those investors all the benefits of owning real property without actually working to own that real property. To accomplish this, investors will usually invest alongside a professional real estate company, often called a “syndicator,” “operator,” or “sponsor”, that will spend the time needed to find an attractive property and to perform the related due diligence, underwriting and management chores. Such companies typically invite other investors to provide some (or most) of the capital required for any single opportunity, and these investors will then share in the project’s benefits (and risks).
Most real estate investments are structured using limited liability companies so that neither the participants, nor the investing members, nor the sponsors will (generally) be financially liable for the venture beyond the value of their investment. The structuring issues then come down to questions of how to divide the financial benefits of the project among the investing members and the sponsor, or “who gets what and how much?”
In most private syndications, the sponsor provides a relatively small portion of the capital for the investment, but does the work of finding the investment opportunity and offers the time and expertise to make the project successful. The investors provide most of the money, but also get to take a relatively “hands-off” or passive approach to the project. How to best split up the rewards? For investors, a partial risk/benefit analysis might include the following:
- Property type/class, operational concerns, market conditions
- Sponsor may not devote sufficient efforts to a faltering project
- Sponsor may be motivated to move on and thus sell the property too cheaply
- Sponsor's interests may not otherwise be fully aligned with those of investors
- Sponsor can bring expertise that investors can leverage
- Sponsors with enough “skin in the game” will work hard toward success
- Sponsors with a significant share in the upside will try to maximize a sale price
- Structured with proper incentives, project can represent an attractive opportunity
The negotiations involved in resolving these issues vary with each transaction, depending on the anticipated risks and benefits involved in the particular project. The primary structuring questions in real estate syndications are usually:
- How much capital will the parties provide?
- Will there be a “preferred return” before sharing any additional profits?
- How will those remaining profits be split?
- Will the sponsor be entitled to a management fee or other payments?
- Who will get any available tax benefits?
Over time, there have emerged some general patterns for real estate equity deal structures. Although each transaction is different, typical structures might look like the following:
- Provide the vast majority of the capital (usually 80-95%)
- Receive a “preferred return” on their investment (often 5-10%)
- Receive a share of the remaining cash flow and profits (typically 50-80%)
- Receive the bulk of the tax benefits, such as depreciation and interest deductions
- Provides a small portion of the capital (usually 5-20%)
- Receives the same preferred return as investors on its own invested capital
- Receives a “promote” share of the remaining cash flow and profits
- May receive fees relating to property acquisition, loan financing and management
- Receives some share of the tax benefits
The sponsor will be managing the project and may not want to invest much of its own capital as a result; but investors should generally look for sponsors that contribute at least 5% of the equity capital for the project. A structure where the sponsor has sufficient “skin in the game” acts to better align the interests of the sponsor and the investors.
Investors putting cash into a project also generally receive some “preference” in the return of that money before any “sweat equity” gets compensated. The preferred return, often in the 5-10% range, means that the investors will receive that amount before the sponsor gets paid any “promote” share of distributable cash flow. The preferred return is not a guaranteed dividend, however; sometimes the preferred return is not paid out because the property cash flows don’t allow it (for example, where the property is still under development). In such cases, the preferred return typically continues to accrue, and any unpaid amounts are ultimately recouped by the investor when the property is sold.
Real estate projects sometimes utilize alternative structures. One different arrangement is utilized largely because it is straightforward – a “95/5” split. With this structure, the investors are entitled to 95% of distributable cash, and the sponsor gets 5%. This clear-cut arrangement eliminates lengthy negotiations between sponsors and investors over the size of any preferred return or the outline of any “promote” arrangement. It also simplifies payout and distribution schedules, and puts the sponsor on a more equal footing with investors – although investors still get the lion’s share of the deal profits.
How do investors find out about these private real estate investments?
Historically, to get access to private real estate investments, most investors were limited to the extent of their personal network. These transactions have been done for centuries amongst friends and family, but only recently have they been opened up more broadly to greater numbers of investors. Today, there are certain market participants like our company, Realty Mogul, that provide investors with curated transactions attached to curated sponsors who have a history and a track record of succeeding in private real estate transactions. When we curate these investments, we look at a variety of structures and the structures presented above are some of the more common methods we see. The important thing is that real estate investments be made under a structure that helps to keep aligned the interests of both the sponsor and the investors.
What do you think? Have you invested in real estate via a syndicator? How did it work out? Comment below! Or read part 5 of this series here.