Syndications Explained Part 1
Hi, I’m Dan with the High Yield Real Estate Investing Podcast
Are you thinking about investing passively in real estate syndication but don’t know how to evaluate a deal presented to you by a syndicator? Let’s go over how the returns on your investment are presented to you in part one of this multi part series. We’ll cover the metrics used to evaluate the deal and what you have to do to qualify for the deal. Hopefully, after you’re done listening to this series, you’ll know what to expect when you open a syndicators deal package and what the steps are to make your investment. After all, if you don’t understand what you’re investing in you probably won’t give anyone your money.
First, what do you have to do qualify to invest in a syndication? Well, that depends on the specific SEC rules that the investment is being offered under. Most syndicators prefer to only work with accredited investors since they are allowed to advertise their deal. These are known as 506(c) syndications. That makes it easier for them to attract more investors to their deal. If you’re not sure if you’re accredited or not, listen to our episode on it. If you’re unaccredited, you can still invest in a syndication as long as it’s a 506(b) syndication. These investments can have unlimited accredited investors and up to 35 unaccredited investors. These deals can’t be advertised to the public and you must have a pre-existing and substantive relationship with the syndicator first. The substantive part means that the syndicator must make sure you can evaluate the merits and risks of the investment being offered. Usually, that’s established with a quick phone call.
Let’s say you’ve established a relationship with a syndicator and have expressed interest in their next deal. When their next investment is available, they send you an email and you download their investment package that includes all the details regarding the investment. In it, you’ll see a lot of information about the property that the syndicator deems important for you to determine whether you want to invest or not. Let’s talk about the metrics used to measure the returns. The most common metrics used to illustrate the returns for real estate are cash-on-cash(C-O-C), internal rate of return (I-R-R), and Average Annual Return (A-A-R). Let’s start with cash on cash.
Your cash on cash return is simply the amount of cash distributions you get in a year divided by the amount you invested. 5,000 in distributions from a 50,000 dollar investment gives you a 10% cash on cash return for the year. Since investment in real estate syndications generally occur over a multi year period, your cash on cash return should ideally increase every year. After all, rents have been increasing nationally every year and you’d expect to see your cash on cash return grow every year as a result. If you’re investing in a value-add deal where there are improvements to be made of the property with the expectation of increasing the rent, then you’ll also expect to see significant improvements in the cash on cash return each year. For simplicity, the cash on cash returns for each year may be averaged together and presented as one number. But what kind of cash on cash return should you look for? Well, depends on the class of property. We’ll assume you’re looking at multifamily here. If you invest in class A properties that are newly constructed and command the highest rent premiums, but also cost the most, you may not get a high cash on cash return. Maybe 4-6%. However, you invest in a really huge complex, like 300-400 units, then your cash on cash may be higher. Class B&C properties should have a higher cash on cash. Around 7 to 8% and up. Personally, if I can offer investors an 8% cash on cash or higher, I’m happy. Cash on Cash is a great metric to see what kind of cash flow you can count on each year. However, it doesn’t take into account some other important investment returns.
Average Annual Return takes into account the cashflow, principle paydown of the loan, and appreciation of the property upon sale. Since these are the three ways you make money in real estate, this metric shows you what your yearly return will average out to at the end of the investment. Very simply, add all of your cashflow over the years and the payout from amortization and appreciation you get when the property is sold and divide by your initial investment amount. This gives you your total return. Divide that number by the number of year of your investment and you get your AAR. If you’re seeing a 13% and above number, then you’re doing pretty well. If you’re investing in class A and B properties or a significant value-add, then expect most of you return to be from appreciation of the property. If you’re investing in a class C property or other stabilized property with lots of cash flow, then expect most of you return to be from cashflow. Of the Cash on Cash, AAR, and IRR that we’ll discuss next, the AAR number tends to be the highest.
Internal Rate of Return is a complex number to calculate and explain. However, it’s the most accurate way to calculate your return on a real estate investment. Simply put, IRR takes into account the time value of money by measuring as the magnitude and timing of the cash flows you receive. Are you lost yet? It’s OK. Let’s consider a few scenarios to illustrate the point. Number 1. You invest 25,0000 into a syndication. 1 year later the syndicator cuts you a cashflow check for 2,500 dollars then sells the property and gives you all your money back. Your return? 10%. Number 2. You get no cashflow for 5 years then the investor sells the property and you get your money back plus 2,500 dollars. Your return is still 10%. Scenario 3. You invest 25,000 dollars in a syndication, get $500 in cash flow each year for 5 years. After 5 years the investment is sold, and you get your money back. Your return is still 10%. Which of these scenarios appeals the most to you? Probably number 1. You get your money and a return back after 1 year. Which is the worst? Scenario 2. You have to wait 5 years to get any return at all.
While the simple return is the same for each scenario; the first one has the greatest time value. I excluded any return from property appreciation on purpose for the examples, but that money would be included in the IRR calculation as well. A true IRR calculation must be done by a financial calculator or excel spreadsheet. While it’s a very complex calculation, it’s the best one there is for calculating the returns on a real estate investment. After all, when and how you get your investment returns and investment capital returned is important to consider when investing in a syndication. Many experienced passive investors care more about the return OF their capital more than the return ON their capital.
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