Complete Guide to Real Estate Syndication E-course (2021)

IRR is the most used calculation in private equity real estate investments, but what exactly is IRR?

The IRR (internal rate of return) is a time-weighted return metric that is common in both financial accounting and real estate investing, where the time value of money and liquidity risk are major factors in investment decisions. IRR represents how long it will take for your money to be returned over time and it shows how hard your money is working.

A waterfall refers to the overall distribution of funds and tiers but it is often explains how profits are split after the preferred return (e.g., 70% limited partner and the 30% general partner split).

As an LP I don't really like these because they are confusing and can be skewed all types of ways. Complexity usually benefits the house (GP) which is why Wall Street tries to make things confusing to un-impower the masses. Ok that might be a little of my opinion but here is what I think about traditional investing.

A preferred return relates to receiving a priority treatment as it relates to the return on your initial capital invested.

By contract, in preferred equity you would be in a priority position in the capital stack to receive your returns during the hold period and in a priority position to receive your initial capital back first when the asset is sold.

In the right financial profile it might be a good idea to diversify your investments in a portion of preferred equity positions to lower the risk profile of your overall portfolio. Remember having 25% of your portfolio making 20% a year is great except the other 75% is lazy equity not making jack in your home, bank account, or stock portfolio. In that situation, brining over a chunk of your 0-5% lazy equity to a pref equity position making 8-12% might really move the needle for you.

The risk is reduced since the preferred equity positions in the capital stack are typically only 10-30% of the overall equity portion of the capital stack. As a preferred equity investor, you would receive your specified return and your initial capital back before any of the other investors. The tradeoff is that your preferred equity returns will be lower and upside limited compared to what you can otherwise get as an LP investor due to the “less risky” position of your preferred equity in the capital stack.

Pref equity means that you also get share of the depreciation!

*Check with your sponsor of course to be sure.

Differences between Pref-Equity

This is going to confuse you if you do not understand the use of A1 or Preferred equity on the deal. Sometimes you can have one large player take up the entire Pref Equity in a capital stack.

If you wanted to manipulate the total return, the one cell on the spreadsheet that is the go to "fudge this cell" or "sharpen the pencil" is the Reversion (Exit) Cap Rate.

You want to see the Reversion (Exit) Cap Rate 0.5%-1.0% higher than the Market Cap Rate. Notice I am using the Market Cap Rate for similar assets (Class A, B, or C) in similar submarkets (locations within the same city), NOT the Subject Property Cap Rate.

On class B/C investments, I have been using 6.5-7.5% reversion cap (2019) depending on market. These days nothing is over 7.5% cap (unless it's a truly off-market deal and a fringe deal under 60-units).

Exception: Only case where you might do a -0.25 to +0.5 cap rate reversion increase because you are doing medium to heavy value add (15k-50k per unit) therefore taking a B/C class property to an A/B+.

The biggest risk in all real estate deals is keeping it occupied (or economic occupancy - people actually paying). One way of determining this is asking what the break even point is.

Be careful that this stat can be manipulated and you as the investor need to be sophisticated enough to ask the right question (or fall victim to "syndicator rope-a-dope") - for example if you asking for occupancy (w/ assumed 3% economic vacancy) or economic occupancy with economic vacancy accounted for? Also is rent increases included.

Now this can start to get very difficult to pin down a sponsor for a real number but its a start and at least you are aware of these games. We don't like to assume that the "full occupancy" will be greater than 92-95% occupied (especially in the first year) plus the assumption that ~3% of those tenants will not pay therefore bringing max economic occupancy down to 89-82% economic occupancy.

PS. Reversion cap (6%) looks really conservative however this deal is near Waco Tx (smaller tertiary/"turd"tiary market) where reversion caps should be much higher than solid secondary and tertiary markets

Syndication Structure

These investments are typically organized as partnerships in the form of LPs (limited partnerships) or LLCs (limited liability companies). Investors are treated as passive partners for tax purposes.

Most investment funds prefer the partnership tax structure over the corporate structure to avoid double taxation, to allow for the fund's income to be taxed at the investor level, and to provide for the flow-through treatment of income, expenses, gains, and losses.

This structure allows you to compound 100% of the fund’s proceeds for years, as long as you do not distribute the gains outside of the fund.

For instance, let’s say you are investing in a syndication where the sponsor is purchasing a fully occupied apartment building and holding it for cash flow:

During the Lifetime of the Investment

Because of depreciation, interest payment write offs, and so on, your annual tax exposure for this opportunity will usually be zero or even negative, even if you receive thousands of dollars in distributions from the property's cash flow.

When the Property is Sold

Only when the property is sold, then investors will pay taxes on the Capital Gains or Distributions from the sale or liquidation of a partnership interest. It will be treated as capital gains- short- term or long- term, depending on the holding period. The amount of recognizable capital gains will be directly impacted by the partner's basis in the partnership interest (i.e. outside basis, capital account balance).

Begin with the End in Mind

Most people will be financially free in 4-7 years pending taking action and being able to save at least 30-50k a year to put to more investments. Begin with the end in mind and design your ideal life now. You are fortunate to be on the path to being financially free and it is a privilege so please do something with it and make a positing impact in the world.

Having passive cashflow is the simple part, the hard part is figuring out what meaningful thing to after. Money and time are interchangeable resources. When you start out Money is worth more than Time. But in time, it will transition to being more valuable.

Ben-Shahar shares four archetypes in his book called Happier outlines how we fall into these four "the happiness archetypes":

• Rat Racer - enjoy the idea of a future destination, but neglect the present

• Hedonist - enjoy the journey (right now), but neglect the future

• Nihilist - enjoy reliving the past, but neglect the present & future (because it's hopeless)

• Happiness - enjoy the experience of climbing toward the peak

The happiness archetype is the ideal archetype.

Economic Occupancy/Vacancy: leased units not collecting rent - (people that live there, but don’t pay)

• As opposed to non leased units

• Occupied units with tenant not paying

  • Doesn’t take into account tenants paying late

  • Aka “bad debt”

• Pro forma should take into account both

  • 2-3% typically non-paying tenants

  • 92% leased-up units considered “full occupancy”

When business losing money, different levels of cash infusion

• General Partners give a loan

• LPs asked to give a loan

  • 5%, 8%, 10%

  • 6-12 month loans

• Capital call

  • Not necessarily going to be a large amount per share b/c if everyone in the deal chipped in a bit then it turned into a large amount of money

  • Similar to having a rental property where the investor may have to pay for a large unexpected expense and not cash flow for a couple months. It happens

  • If something dramatically bad happens - can just fire sale the deal and get out

  • If cannot do the capital call - then my shares get diluted, nothing else happens

• Ask to look at T12 and see what was worst month in terms of NOI

  • If negative month(s), how many months with the capital reserves carry the business before reserves are exhausted?

General goal to double investors money (100% return) in around 5 years

• Returns will go down as CAP rates compress in the coming years

• Cash flow based deals will be yield deals: Lower total returns

• If forgo cash flow (large value add): then a larger return upon sale

Refinancing

• Try to analyze deals assuming no refinance

  • Refinance assumes the best case scenario

  • If value-add and property value goes up, might want to take that value and refinance it out for cash to put somewhere else that will also make you money

  • Commercial prices based off NOI, Residential based off comps

  • Refinance not taxable to investor as considered a return of equity

  • Refinancing will decrease the cash flows based off of the higher loan amount/debt payment. So while while the refi is best case scenario, if you take the same scenario and don't refi, this will increase cash flows and total return on exit

• Forced value appreciation of the asset by increasing NOI

  • Increased NOI will allow for bank supplemental loan on the new (higher) value

  • Take out equity, original investment back

    • May or may not dilute shares (stated in the operating agreement)

    • “Infinite returns”: Had refinance, got initial investment out, but still generating returns with no more money in the deal

• Not taxable money

  • It’s a loan

Deals with a preferential return, “pref”

• Usually if a deal has a pref, the GPs are just getting more on the backend than they would otherwise

• Lots of different ways GPs structure deals

  • Pref, 80/20, 70/30, waterfalls

• Ultimately, look at what the returns will be every year and total return at disposition

  • Look for page that shows example, “If you invest $100k, expect x return”

  • Everything else superfluous

  • If the sponsor doesn’t live up to the pro forma, don’t invest with them again

Be wary of deals with quick exits (3 years)

• Riskier because less room for error if there is a market downturn and they are contractually forced to sell in a bad year

Annual Rent Escalations

• Market specific

• Normally 2-3%

  • 5-6% is too aggressive

  • This is separate from the initial increase in rents at acquisition

  • $8-10k rehab unit is significant and enough to increase C class to B class

Need to come up with personal investor philosophy

• How much risk am I willing to take

• What’s the acceptable amount of reward

• Cash flow vs value add/appreciation, yield vs ROI - what are your goals?

• Work with bigger institutions?

  • More reliable, but more fees

GP will analyze deals looking at the investor return

• If the LP return is above the 100% return in 5 years, the GP will adjust the GP/LP splits to bring it down to 100%

• If you see a deal with 100% return and 50/50 GP/LP split, it’s a fat deal

  • If that deal goes “wrong” and the asset doesn’t perform as expected, would the GP revise the splits to keep the LPs happy at proforma return?

    • Instead of 50/50 its 70/30 but LPs still 100% return

Sucker Deals

• Multiple syndicators trying to raise money

• 5 % rent escalations

• Exit cap rates the same or go down

  • Assume will sell in a stronger market as opposed to weaker

• Loan Guaranty fee should be included in the Acquisition fee %

GP Deal Structuring

• What do you first look at when forming the payout structure of the deal to the LP/GP?

• How do GPs choose whether it’s a pref + waterfall, waterfall only, refi the LP out or refi and keep the LP in?

• Should the LP verify these numbers they’re being paid or the GP is being paid in comparison so the LP isn’t getting ripped off? How would they do this?

• Verifying the stress test: how should investors do this? Better to trust the Sponsor?

  
  

Vetting the Sponsor

• Should we conduct background checks, if so when appropriate?

• Red flags to look for?

• Tactics sponsor might use to target unsophisticated investors?

  
  

Deal Defaults

• What happens when a secured syndication project defaults?

• How long does it take to recoup some of your investment?

• What are the chances of an investor getting any of their money back?

• Is there a general amount the investor can expect to get back or a way for them to figure out/calculate the amount they might recoup or is there too many external factors?

• Is there anything an LP can do during a default or foreclosure?

Assembling a Team

• Who are all the key players in a syndication deal?

• How do you find each team member and vet them

• How do you each work together to put together and execute the project?

• Is there a system of checks and balances?

• How many people does the sponsor split the profit with on the team? Or does the sponsor make the profit alone and pays the other team members out a salary?

Property Management

• Do sponsors ever have an in-house PM company or is it always outsourced?

• How do you vet the current PM company? When you go to replace the team, how do you find a replacement PM company in the area? Do you ever hire a major PM company to oversee that just places a team on-site?

  
  

Construction Teams

• How do you find and vet construction team for your value-add?

• How do you find and vet technicians and porters for the property? If this the PM’s job, do you entrust they will hire labor with reasonable expenses and quality work?

• How do you check-in to ensure that construction is being done on time and with quality?

• How often does the operator physically visit the property to inspect project and PM?

  
  

PPM

• What are you looking for in the PPM: red flags, key terms, key areas

• Most important pages

  
  

Development/Heavy Value-Add

• Do we not care if the project is a shorter term 3 year project if a development like we care when it’s a cash flow deal and looking for a longer 5 year timeline?

• Are there certain cycles when development projects are better to invest in than others?