The Advantages of Being a Limited Partner in Real Estate Syndications
It's...mostly...passive income
"Teamwork is the secret that makes common people achieve uncommon results." – Ifeanyi Enoch Onuoha
Investing in real estate isn’t easy. Early on, when I first discovered it, a few of the people I was listening to made it sound that way though. After some trials and tribulations in the single family space, a global pandemic, and a year of self educating on the history of macroeconomics and its application to current society, I came back to real estate determined to make it work the way I knew it could. For one, I was (still am!) tired of being an employee. But more importantly, my newfound understanding of macroeconomics made success in real estate an imperative.
One of the first and easiest mistakes to correct is summed up in the above quote: teamwork. I found that the key to real estate investing, and especially so in multifamily investing, is teamwork. This was something other “experts” had been talking about, but I didn’t know who these people were at the time. Careful who your teachers are!
Syndications allow regular people, who are not necessarily real estate experts, to partake in the benefits of real estate investing. Limited partners can take advantage of a sponsor’s market knowledge, relationships, and business savvy. They can also de-risk their investment by investing into a group deal while still receiving the full tax benefits that real estate provides. And the best part, it is one of the most passive ways to invest in real estate.
Invest with Experts
The best sponsors can be seen as “insiders”. They are experts on the population trends, income trends, and future development plans in their particular markets. They often have relationships with brokers, lenders, insurance providers, property managers, and even city council-people. They know which areas to invest in, which to avoid, and even which side of the street is “the good one”. Oftentimes, sponsors have walked many of the apartment buildings in the submarkets they are focused on investing in.
Additionally, the best sponsors have a business plan that they execute over and over. It might be lease up on newly built properties, value-add via rehabs on older properties, or simply running a property more efficiently to increase its value. Whatever the strategy, oftentimes the sponsors choose to focus on one and then scale that as far as they can. This is done by creating the relationships and processes needed for the particular strategy, and then executing while constantly making it more efficient.
A limited partner (LP) can leverage this level of expertise and business savvy. They can invest in multiple markets without having to spend months building all the relationships listed above in each market. They can invest in lease up projects and value-add projects without needing to be an operational luminary in each strategy. What a great advantage!
Spread the Risk
LPs can also spread their risk in a real estate deal. This is actually a unique advantage of real estate in general. At the very least, an investor has a bank looking at the deal. But in a multifamily syndication, there can be quite a few more parties evaluating the deal.
Obviously, the general partners evaluate the deal in depth. Since it is on them to execute the business plan, they will stress test the deal, look for threats and possible downsides, and negotiate to cover those risks. If you invest with a well known and experienced syndicator, they also have their reputation to uphold. A long career syndicating deals can be ruined with one bad deal. General partners are very aware of that.
Second, the lender also underwrites the deal vigorously. With memories of the 2008 liquidity crisis still fresh, banks and lenders are constantly stressing the deal to see if it works. The primary metric they look at is the debt service coverage ratio or DSCR. This ratio tells the bank how much income to debt the property will make. Generally, lenders look for 1.25, though in tough times they can increase their requirement to 1.3 or 1.4. Another way of thinking about this ratio is this: At a 1.25 DSCR, the property must make $1.25 in income for every $1 of debt the bank lends. This insures some buffer in case something does go wrong during the hold of the property. An LP must recognize the bank is only looking out for themselves, but that 25% minimum buffer can help an LP gauge the health of the deal
Third, some deals might have preferred equity onboard. Preferred equity is a type of equity that is “lower” in the capital stack (their position is “closer” to the property). They get paid out before the common equity. In exchange for this more secure position, preferred equity also receives lower returns generally. Usually, preferred equity is family office money or big private equity funds. LPs, who are part of common equity, can leverage this “smart” money. If preferred equity groups are investing, then the deal, then you are assured another layer of intelligent investors is inspecting the deal. As with the lender, an LP must know the preferred equity is only looking out for themselves, but it can be used as another leverage point for evaluating the deal. It’s also worth noting that preferred equity does pose an extra layer of risk for an LP - remember, if something goes wrong, the preferred equity gets paid out first.
Finally, an individual LP can look at the common equity interest in the deal. If your sponsor is struggling to raise the capital for the deal, that might mean it’s not as good as they think. This is hardly definitive, but another leverage point or evaluating the deal.
All of these points of evaluation means the risk of the deal is being spread amongst many actors. Rather than having the entire deal rest on an LP’s money, there are multiple parties involved.
Full Tax Benefits
A LP gets ALL tax benefits associated with real estate investments. It’s as if the LP owns the property themself (because they technically do). The general partnership will distribute schedule K1s every year which will specify the income, deductions, and expenses for the property. Any depreciation on the property also passes through to the LP.
This is powerful because it creates a scenario where the LP might be able to legally pay $0 in taxes on the cash flow generated by the property.
Additionally, if the GP is accommodative, it is possible for an LP to do an IRS Tax Code Section 1031 Like Kind Exchange both into and out of a syndication. All tax benefits associated with a 1031 Like Kind Exchange are possible for LPs in syndications. Technically speaking, being a 1031 investor in a syndicated deal means you are not a "Limited Partner”, but rather, a co-owner. The details of this can be explored in a separate post.
It’s (Mostly) Passive
The biggest benefit of being a limited partner in a syndication is that it is passive. By passive, I mean a LP is not running the business. They don’t have to deal with hiring and managing the property manager, worrying with asset management and accounting, or dealing with lenders and brokers to buy or sell the property. It’s the closest thing to “mailbox money” that exists.
With that said, there are some things that a smart LP does up front. Sure, they are not sending direct mail to potential sellers, underwriting hundreds of properties to get a single one under contract, or going through the physical due diligence on the property, but there are a few things that should be done.
Most importantly, the sponsor should be vetted. The old adage is do business with those you know, like, and trust. That is certainly true. But an LP should also look at the sponsors experience and track record.
For instance, here are a few questions that can be asked of a sponsor:
How many deals has the sponsor done?
Do they have experience with this type of business plan?
Did they hit the returns on their previous deals?
What was the worst deal they did and how did it turn out?
There are many other questions that can be asked. Mauricio Rauld did a great zoom on this which can be found here.
Second, an LP should vet the market. What does job and population growth look like? If either of these are not growing, will there be enough demand to keep the property filled? What does job diversity look like? A single industry town is very easily wiped out. What is the upcoming supply? If new construction is outpacing in-migration, it will be hard to keep the property filled and rents high.
Finally, the deal itself should be vetted. There is some individual-ness to this process. Checking that income and expense projections are reasonable is pretty universal. But other things are a little more fluid. What’s the LP’s comfort with the exit cap rate for the market? Do they care about the minutia found in the due diligence reports? These, and others, are questions each LP must have and answer for themselves. Some investors care if the property is too close to the water for instance, others don’t care about that at all. In any case, the deal itself is actually the last thing to vet after the sponsor and the market.
Conclusion
So, this is a short list of benefits to being a limited partner in a real estate syndication. You can invest with real estate experts, leveraging their years of experience and reputation. You can spread the risk over many parties instead of taking on all the risk yourself. All tax benefits associated with real estate are still available to you. And, finally, the thing everyone wants, it creates the closest thing to “mailbox money” you can find.
At SwiftCity Capital, I work with experienced team members to find multifamily deals that give our investors all these benefits. Check us out and don’t hesitate to reach out!