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Apartment Syndication 101: What Doctors Should Know

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I recently spoke to a group of periodontists about apartment syndication investing.

As you can imagine, the majority did not have any prior real estate experience and were comfortable following their financial adviser’s advice of 401k investing until age 70+.

I occasionally visit investing forums and Facebook groups for doctors.

Most are discussing:

  • what index funds to buy
  • should you use an adviser?
  • the latest cryptocurrency fad
  • what percentage of stocks and bonds is best?

It’s amazing that many of these people have been practicing over twenty years and NEVER mention real estate investing. 

Look, I used to read all the finance magazines such as:

  • Kiplinger’s Personal Finance
  • Money 

What’s the common thread these magazines are pitching?

You guessed it, Wall Street investing.

For years I was focused on which index funds had the lowest fees and the ones that had the longest track record with best returns. 

After I began investing in apartment complexes, I realized that the 8 -10 figure net worth people had made their money via real estate.

Not a 401k. 

Hmmmmmm.

I have no issue getting investment advice. Just don’t give me ONLY one option. To me that’s unethical.

What I’ve noticed is there’s two main ways to build wealth.

#1. Stock market (retirement accounts) – for those wanting to build wealth slowly with little to no thinking involved (only focused on annual return) yet risky due to volatility

#2. Real estate investing – allows you to build wealth as quickly as you want, could use other people’s money (OPM), unbelievable tax advantages providing options to retire early. 

It’s now up to you to choose.

I started off the first 12 years in practice following method #1 above because I didn’t know anything about #2. 

I’m now on a mission revealing what I’m experiencing (cash flow to replace active income + tax benefits + common mistakes) to have options when it comes to retiring. 

Let’s get started… 


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What is an Apartment Syndication?

An apartment or real estate syndication deal involves the pooling of money from several investors in order to purchase a physical property that’s more expensive than any of them could have afforded on their own.

These investments are governed by the Securities and Exchange Commission (SEC) and must file documentation such as a private placement memorandum.

Who Can Invest?

Originally syndication deals were exclusive to the ultra-wealthy but now are much more accessible. This is mainly due to the emergence of real estate crowdfunding since the JOBS Act passed in 2012. 

Most syndications are reserved to the accredited investor which is defined as:

  • A person with an annual income of at least $200,000 in each of the two most recent years or married couples making $300,000 joint income. There must be a reasonable expectation of the same income level in the current year; or
  • A person or married couple with a net worth of at least $1 million which does NOT include a primary residence.

Who’s Involved?

There are two types of partners in these deals:

#1. General Partner/Sponsor/Syndicator (GPs)

The GP is an owner of a partnership that has unlimited liability that’s active in the day-to-day operations of the business. 

Their job is to:

  • select target investing market
  • perform inspections
  • handle due diligence process
  • run the numbers
  • place asset under contract
  • source capital from passive investors
  • obtain the loan
  • keep it occupied
  • manage the property

#2. Limited Partner (LPs) 

They’re also known as the passive investors. They’re responsible for funding a portion of the initial equity investment having zero control over any aspect of the business plan.

Examples include a physician working full time NOT wanting to deal with tenants remaining hands off.

Other parties involved are:

#3. Property Management Company

Many GPs hire a property manager whose main responsibilities are:

  • manage the day-to-day operations
  • execute the GP’s business plan

Potential additional services that great companies provide are:

  • advise on attractive or struggling neighborhoods within a market
  • offer locations of prospective properties based on the GP’s business model
  • provide a pro forma (i.e., projected financials) on prospective properties based on how they would manage them

#4. Commercial Real Estate Broker

Syndicators having great relationships with brokers typically are able to find the best deals.  Most work with multiple different brokers obtaining access to either on-market or off-market deals.

Brokers will put together the offering memorandum (marketing package) to the GPs. 

For on-market deals, the broker typically:

  • manages the offer process
  • ensures deal arrives at the closing table once it’s awarded to an investor

#5. Real Estate and Securities Attorney

The two attorneys involved in an apartment syndication are:

  • real estate attorneys
  • securities attorneys

They’re responsible for developing and reviewing the 4 major contracts:

  • Purchase sale agreement
  • Operating agreement
  • Private placement memorandum
  • Subscription agreement

a. Purchase and sale agreement

A purchase and sale agreement (PSA) is a legally binding document between the buyer and seller of a property that establishes the terms and conditions related to a real estate transaction.

It states what requirements the buyer must meet along with:

  • purchase price
  • limitations
  • contingencies

The PSA is usually created by the real estate attorney representing the seller but the buying party should always have their real estate attorney review before signing.

b. Operating agreement

In an apartment syndication, there’s two types of operating agreements:

  • Operating agreement between members of the GP (if the GP is made up or more than one member – would outline responsibilities and ownership percentages of each.)
  • Operating agreement between the GP and the LP. Outlines responsibilities and ownership percentages for both the GP and LP. 

c. Private placement memorandum

A private placement memorandum (PPM) is a legal document that lays out the details and disclosures of an apartment syndication. It discloses all of the important information an investor may want to know before agreeing to the terms (such as how LPs could lose their money).

When investors are reviewing an investment opportunity, the contents of the PPM should include everything that’s needed to make an informed decision such as but not limited to:

  • summary of the offering
  • minimum and maximum investment amounts
  • description of the asset
  • key risks involved
  • disclosure on how the GP and LP are paid

The PPM should be prepared by a securities attorney for each apartment deal.

d. Subscription agreement

According to Investopedia, a subscription agreement is an investor’s application to join a limited partnership (LP) and is prepared by a real estate attorney. It’s also a two-way guarantee between a company and a new shareholder (subscriber or LP).

The company (LLC that owns the apartment) agrees to sell a certain number of shares at a specific price (to the LPs) and, in return, the LP promises to buy the shares at the predetermined price. 

What Are the Main Types of Apartment Syndications?

More than likely the syndicator is either selling private securities to the limited partners under Rule 506b or 506c.

506(b)

Here are the general guidelines if someone sells securities under the 506b exception:

  • General solicitation or advertising of the securities offerings is prohibited
  • Able to sell to an unlimited number of accredited investors and up to 35 non-accredited (but “sophisticated”) investors
  • Issuer may rely on investor self-certification
  • Issuer must have a pre-existing, substantive relationship with potential investors

506(c)

Under this rule, those selling securities can advertise if they accept accredited investors only and must be able to demonstrate they took “reasonable steps” to ensure the accredited investors status of all investors at the time of the investment.

In other words, the issuer must verify that the investors are accredited.

To do so, a 3rd party is involved such as a CPA, attorney, or a registered broker-dealer. They can review the investors financials, such as W-2s, tax returns, brokerage statements, and credit reports.

You could also go to a website such as Verify Investor to have this done as well. 

Unlike 506b, self-certification is not permissible.

The main differences between the 506(b) and 506(c) are:

  • Solicitation is prohibited for 506(b) but permitted for 506(c)
  • Non-accredited investors may invest in 506(b) but not 506(c)
  • Self-certification of investor status is permitted for 506(b) but not 506(c)
  • You must have a substantive, pre-existing relationship for 506(b) but not 506(c)
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How Do General Partners Make Money?

#1 Acquisition Fee

This is an upfront fee that the sponsor charges on the purchase of a property at closing. These usually range from 1-5% of the purchase price depending on the size, scope, experience of the GP, and profit potential.

This fee represents the work it took to acquire the deal and put it together. It’s earned at the close of escrow on the acquisition.

They also have other costs involved in finding deals such as:

  • air travel
  • hotels
  • employee salaries

#2 Asset Management Fee

This is an ongoing fee that compensates the sponsor for their management of the property during the course of the investment.

Duties include:

  • goal setting and meeting deadlines
  • communication facilitation between investors
  • taking care of the day-to-day operating issues 

Typically this fee is 2-3% of the gross revenue collected from the property and its usually paid quarterly.

The size of the fee depends on level of work required to implement the business plan and the experience level of the GP.

#3. Profit Split

Whether you’re a passive investor or GP in an apartment syndication, you can expect to be compensated when the property is sold.

Typically, the total profit split between the GP and LP can range from:

  • 50/50 (LP/GP)
  • 70/30 (LP/GP)
  • 90/10 (LP/GP)

If the syndication is structured where the limited partners are offered a preferred return, the remaining cash flow after the preferred return is distributed is split between the LP and GP. This is the equivalent of interest on their invested capital plus the majority of any profits.

Once the LPs receive the remainder of their equity investment after the property sells, the GPs receive a catch-up distribution based on the profit split. After this takes place then any remaining profits are split between the LP and GP.

#4. Guaranty Fee

At the closing, the loan guarantor (signs on and guarantees the loan) is paid a one-time fee called the guaranty fee.

The loan guarantor could be partners in the GP or a 3rd party.

If it’s a 3rd party, they would have to meet the liquidity, net worth, and/or experience requirements needed to qualify for financing. The GP typically offers them 10% to 30% of the GP in addition to or instead of a one-time fee.

If members of the GP are the loan guarantor, they’ll typically charge 2-3% of the loan amount but could vary depending upon the size of the loan.

#5. Refinance Fee

If a refinance occurs during the project, a refinancing fee is paid to the GP as compensation for the work required to refinance the property.

In most cases, this fee would be 0.5% of the new loan amount obtained.

How Do Limited Partners Make Money?

There’s typically three ways LPs are compensated in an apartment syndication.

#1. Preferred return

A preferred return refers to the order in which profits from a syndication are distributed to LPs.

It’s a threshold return that LPs are offered prior to the general partners receiving payment.

Many of the deals I’m currently in pay out a 6% preferred return (pref) on a quarterly basis.

This means that the investors will receive the first portion of the cash flow up to 6%.

If the project cash flows 6%, the LP receive the 6% preferred return and the GP does not receive a profit split. If it cash flows less than 6%, the LP receives a return of less than 6%.

If the project cash flows more than 6%, the LP receive their 6% preferred return and the remaining profits are split between the LP and GP.

Typically, the preferred return is considered a return on capital meaning the distributions do not reduce the LP’s capital account.

#2. Profit split

As discussed earlier, if a preferred return is offered, the remaining profits are split between the LP and GP.

I’ve personally invested in deals where the typical profit splits are:

  • 70/30 (LP/GP)
  • 80/20 (LP/GP)
  • 85/15 (LP/GP)

LPs receive distributions from the profit split on an ongoing basis during the business plan (if the cash flow exceeds the preferred return) and/or at the sale of the apartment building.

#3. Refinance or supplemental loan proceeds

If the syndication ends up refinancing into a new loan and/or secures a supplemental loan, the passive investors will typically receive a distribution that is a portion of their initial equity investment.

The proceeds from a refinance or supplemental loan are typically considered a return of capital which is like the profit split.

This means that the proceeds reduce the LP’s capital account.

Are You Ready To Get Started In Apartment Syndication Investing?

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2 Comments

  1. Nice overview, Jeff.
    I agree that there isn’t much discussion of real estate investing in the popular personal finance/investing press.
    I have successfully invested in real estate for over 20+ years now.
    One question: How important is the pref return for you when looking at options? I have done well with deals with and without it. Thoughts?

    1. Thanks for the kind words WD! Regarding a pref, most of the passive investors like the idea of a “guaranteed” return before the sponsors are paid. It helps put them at ease. But I’m like you, I’ve done well in deals that do and don’t offer that structure.

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