Equity syndications are real estate vehicles that amalgamate cash equity from a variety of investors with the purpose of investing in a particular real estate asset.
The originators of the equity syndication are called Sponsors. The Sponsors are typically either the Managing Member if the investing entity is a limited liability company (LLC) or the General Partner if the investing entity is a Limited Partnership (LP).
Sponsors are typically sophisticated and experienced real estate investors, developers, and/or operators of real estate assets.
The Sponsors arrange the debt financing and assume any recourse requirements that the lender imposes. If the loan in non-recourse, the Sponsors are responsible for the non-recourse carve outs. Non-recourse carveouts determine what acts that a Sponsor would have to do to make the loan recourse to the Sponsor. Non-recourse carveouts typically include what lenders call bad boy acts, which encompass bankruptcy, fraud, waste, and misuse of the property.
Real Estate Sponsors can be active investors that solely invest in a single asset class, asset type, or geographic market. Sponsors can also be active in multiple asset classes, asset types, and geographic locations. Furthermore, Sponsors can also be aggregators of funds in that they manage a fund vehicle that invests in real estate, multiple funds, or they can act as hedge funds, where they manage large amounts of funds, and then decide where to invest that money with other Sponsor’s deals.
Investors in these equity syndications are either called members if the entity that is being invested in is a limited liability company (LLC), or they are considered limited partners if the vehicle being set up is a limited partnership (LP).
Investors bring the majority of the equity to the investment in exchange for a preferred return and percentage of the upside. The preferred return is typically cumulative, but non-compounding. Furthermore, the preferred return is not a guaranteed return per SEC regulations, but a return that the investors earn prior to the Sponsor earning any upside.
Investors are passive in that they do not have control related to operating the investment. They do not have much say in the operations of the property and they do not get to determine when to have a capital event such as a refinance, recapitalization, or a sale.
A major benefit of being a limited partner or a member is that your exposure to the entire deal, or your recourse, is limited to your investment in the particular investment whereas a Sponsor can have more risk and downside should a deal not perform as expected.
Investors also have the benefit of equity leverage.
One of the benefits of equity leverage is that each investor does not have to bring the entirety of the equity needed to close to the transaction. The transactions being invested in are typically larger than what any one passive investor may be interested in making on their own.
A second benefit of equity leverage is that not only will passive investors get diversification by being able to invest in multiple assets in multiple geographies with multiple Sponsors, but the passive investors will also be able to obtain economies of scale since the deals are typically larger.
When deals perform well, investors can make larger returns. Investors should be looking at three factors when they’re investing in terms of the return metrics. The three metrics are cash-on-cash return, internal rate of return (IRR), and equity multiple.
Cash-on-cash returns are calculated by looking at the current cash flow distributed after operating expenses and debt service divided by the initial equity invested in the property or entity that invested in the property.
Internal rates of return (IRR) is a calculation that considers the time value of money. IRRs are calculated by taking into the account the timing of when cash flow is received and the timing of any refinances, recapitalizations, sales, and ultimately the return of capital plus any profits that occur during the ownership once the asset is disposed of.
Equity multiple is a calculation that measure the total cash returns from operating cash flow, refinances, recapitalizations, and the ultimate sale of the property. The calculation is determined by adding up all the cash returned from the property divided by the cash equity invested in the property.
Generally speaking, I look for a 6% minimum cash-on-cash return. I am ideally looking for a minimum 12% IRR. And I am ideally seeking an equity multiples in the 1.50x to 2.00x range at a minimum depending on the investment time horizon.
From a calculation standpoint, we will assume a $100,000 investment in a deal.
From a cash-on-cash perspective, in order to receive a 6% minimum cash-on-cash return, I would anticipate receiving $6,000 per year in cash flow from the $100,000 investment.
From an IRR perspective, I would still anticipate receiving $6,000 per year via cash flow. Over the six year period, that equates to $36,000 in cash flow on the initial $100,000 investment.
If we further assume that the property is held for a 6-year time period, we could expect to receive an additional $6,000 per year over that six year period. Assuming we sell the property at the end of the 6-year period, we could anticipate getting another $36,000 from profit on top of that from appreciation.
Therefore, when you calculate those returns on a time value of money basis with an IRR, the return works out to be about a 12% IRR.
Most of our deals have performed better than that over time, however, we have a few deals that have performed in line with the 12% IRR. We have only had two deals that have effectively been breakeven for us at this point.
The final metric that is important for passive real estate investors is the equity multiple. As we discussed, the equity multiple is effectively the total of all the cash flows that you get over the time period that you hold the property plus the return of capital and any profits you receive upon a sale.
Again, if we invested $100,000 and we received $6,000 per year, then that is $36,000 of cash flow received.
At the end of the 6-year hold period, we also receive our profit, which in our example shows that we received a 12% IRR. The difference between the 12% IRR and the 6% payout means that on average, we would be receiving another $6,000 per year for a total of $12,000 per year.
$12,000 per year multiplied by six years means that we received $72,000 in cash flow and profits from the $100,000 investment. This means that I received my initial $100,000 back from the investment and an additional $72,000 in cash flow and profits for a total of $172,000.
When you divide the $172,000 received by my initial $100,000 investment, that yields a 1.72x equity multiple.
The benefits of equity syndication are that you can obtain economies of scale, it is easy to spread your net worth around over multiple deals, and you can achieve above average risk-adjusted returns.
Equity syndications are an excellent way to obtain diversification and equity leverage. Your goal is to get diversification in various asset types in various geographies, and with multiple sponsors in order to spread your risk and your investment dollars around. The reason for this is so that any one negative event will not significantly impact your ability to maintain your lifestyle.
The other thing that you get, which is hugely important is equity leverage. Equity leverage gives you the ability to scale into larger deals than you would otherwise be able to do on your own. It gives you the ability to have larger profits especially when you are working with a reputable sponsor who knows and understands real estate.
Equity syndications also give you the ability to institute Guardrail Finance’s AIRR method, which is effectively an investment loop where you analyze the deal on the front end, you invest, you refinance, recapitalize, or sell, and then you reinvest that proceeds that you get from the refinance, recapitalization, or sale into new cash flowing deals that can further increase your cash flow and your net worth over time.
Until next time, let’s keep growing our cash flow and net worth together!
-Robert