Have you ever wondered how apartment or office complexes are financed? A typical complex will have 80 to 100 units and the cost of construction will approximate $7,000,000. Where does this money come from? Your average person will think it is financed by a mortgage of some sort. Well, this is partially true, but mortgage companies will not finance 100% of the cost of construction. More like 75% maximum financing is used in constructing complexes. The balance has to come from private money.
This is where the value of real estate syndication comes into play. The arrangement is usually a two tier relationship whereby an operating partnership is created that actually owns and operates the asset (the complex). The second tier is a silent partner in the operating partnership. The following sections explain these two tiers in more detail. After explaining the two tiers I’ll illustrate how the money flows throughout the life cycle of the syndicated deal.
Before reading on, you may need some refresher on some of the terms I use. These include:
- Syndication – a group of individuals working together to accomplish a goal
- Partnership – a relationship between two or individuals or businesses whereby all parties benefit from the group’s existence
- General Partner – the one partner held to a higher standard of performance in the partnership; generally is in charge
- Limited Partner – an individual or business that participates in the financial opportunities from the relationship and generally is not actively involved in the day-to-day operations
This article is not about the current use of the term syndication which in real estate refers to the marketing technique used by agents in selling property. This article is about the traditional use of the term in creating an equity investment in real estate.
A partnership is created, typically formed as a limited partnership. This partnership has two partners, the primary partner is referred to as the general partner (GP) and the other partner is an investment group commonly referred to as the limited partner (LP). This partnership relationship is designed to protect the investment group from any further financial obligation and restrict the ability for any third party to sue the investment group. This operating partnership owns the complex and is responsible for the mortgage on the complex. In addition, this partnership is commonly referred to as the Lower Tier. The following explains the respective responsibilities of the two partners:
In almost every one of these relationships, the general partner puts up very little if any money for the project. Normally they bring their management expertise to the table as their contribution for the partnership. In most situations, the GP has a 5% financial right and figuratively a 100% control position. Most of the partnership agreements rarely limit the control by the GP. More modern relationships are now reserving the rights for the limited partner to remove the GP in regards to performance issues. But the older agreements didn’t address this or restricted the ability of the LP to remove the GP in regards to performance.
The GP makes its money in two income streams. The first is via operations. The GP operates the complex, signs the leases, collects the rent, pays the bills, maintains the facilities and is financially responsible for any shortage of cash in operations. The GP typically collects a management fee of seven to nine percent of collected rents. The second source of income for the GP relates to the last day of the partnership. When the complex is sold and all the bills are paid, the GP generally gets half of the remaining balance (equity) in the complex.
Unlike the GP, the limited partner has no responsibility in the day-to-day operations. In more modern day operating agreements, the limited partner has a right to swap out the GP with another GP to improve performance. But most partnership agreements do not grant this control to the LP; the GP controls the situation. The limited partner is almost 100% of the time some other limited partnership and only has a passive right to the annual earnings. Most agreements are written to distribute 95% of the excess cash (defined differently in each operating agreement) to the LP on an annual basis. Basically, as the complex makes money each year, 95% of this is paid out to the limited partner or what is referred to as the Upper Tier.
The real advantage for the limited partner comes from successful operation and ultimately the increase in value of the real estate over time. When the complex is sold, the idea is that the equity has increased significantly and upon final disbursement of the proceeds, the limited partner investor gets its half. Older partnership agreements restrict the equity rights to about one half of the value, the other half is earned by the GP. More modern day operating agreements structure the arrangement whereby the limited partner gets a larger chunk of that equity value.
The following is a summation of the operating partnership (lower tier partnership):
- Managed by the GP
- Goals are annual earnings and real estate value enhancement over time
- Partnerships life expectancy is no more than 60 years
- Limited Partner is totally passive and has no control rights
- LP has no further financial obligations to the project
- GP owns 5%, LP owns 95%
What is most interesting about this is that the Limited Partner is typically a partnership too. Most limited partners in a syndicated real estate deal are limited partnerships. I know, you are saying to yourself, what in the hell is he talking about?
For those of you that don’t know or may not remember, the partners in a partnership can be pretty much any type of an entity. They include:
- Government Entities
- AND OTHER PARTNERSHIPS
A partnership can become a partner with other entities and this group or business operation can exist as a partnership. Notice in the section above, I said that the operating partnership usually consists of a GP (most often a corporation) and an LP (most often another partnership). This LP is referred to as the Upper Tier and is a partnership itself. It is comprised of at least one general partner, just as in the lower tier arrangement, the GP in the upper tier is a corporation. It is legal, but I have not seen it to date, but the GP at the Upper Tier can be the same GP at the Lower Tier.
In addition to the GP, there is at least one limited partner. Again, this limited partner can be any form of legal business entity. But in almost all cases, the limited partner or partners are individual investors. These individual investors purchase ‘Units’ in the partnership via some form of an offering document which lays out the plan for the business. This is where the term syndication comes into play.
Typically a group of individuals are approached and the plan is presented via the offering document. Each of the investors agrees to purchase a unit, once all the units have been assigned, a closing date is identified and in exchange for the capital, the limited partners receive their unit of ownership. This newly formed partnership is called a Limited Partnership and often carries some term in its name referring to the arrangement. A typical name might be XYZ ASSOCIATES LTD.
What is interesting is that just as in the operating partnership, control rests with the GP. And just like in the lower tier arrangement, the investors are limited in their future financial obligations. The limited partners (the core investors) have very little control and only seek out the value related to ongoing earnings in the operating asset and ultimately the value associated with the equity earned upon the sale of the complex.
The primary positive attributes of this Limited Partnership include:
- Legal protection for the limited investors
- GP has sole financial obligation to manage and report the performance to the limited partners
- Ultimately the complex is sold and the limited partners reap a financial windfall from the increase in value of the property
How do the limited investors get their money back? The best way to explain this is via a life cycle illustration:
Illustration of the Relationship
A property manager identifies an opportunity to construct a 100 unit complex near an expanding major corporation facility. Based on his analysis, he needs to raise $8 Million to purchase the land, construct the complex and begin operations. The bank has agreed to loan $5,600,000 (70%) of the total contingent on the property manager raising the balance. The property manager creates an operating partnership and seeks out investors.
A real estate syndicator agrees to become the limited partner with the property manager and creates an offering document. The syndicator offers to sell 9 units with an 11% limited partner right to a limited partnership. The syndicator agrees to act as the General Partner in this new limited partnership and will receive a 1% ownership position. Notice that now 100% of the limited partnership is assigned – 9 units at 11% each for 99% and the remaining 1% to the GP.
For the purpose of the relationship, the offering document states that a total of $2,700,000 must be raised allocated as follows:
- $2,400,000 to purchase the rights to the Operating Partnership with the property manager as the GP;
- $100,000 for the legal set-up and fees to the respective lawyers and state authorities;
- $50,000 as cash reserves for the Limited Partnership;
- $150,000 to the syndicator for services rendered in putting the deal together.
Now each limited investor pays $300,000 for their 11% ownership position.
Let’s assume that the complex generates around $55,000 net income after principle payments have been made on the note. The operating agreement says that 90% of excess earnings can be paid out to the partners in the partnership based on their respective ownership positions. Thus in this case, 90% of the $55,000 is $49,500. The limited partnership has rights to 95% of this distributable amount. Therefore the limited partnership gets a check for $47,025.
The general partner at the upper tier level (the Limited Partnership) receives the funds and in turn uses the funds to pay the annual legal and tax preparation fees. This leaves $45,450 left as the distributable amount to the entire group of partners. The GP gets his 1% which is $455. The remaining balance of $44,995 is paid out to the limited partners equally (all 9 partners have an equal ownership right). Each limited partner is paid $4,999.44.
Over a course of 15 years, the trend is exactly the same. So, from the perspective of one limited partner, he has invested $300,000 and has received $75,000 back after 15 years.
Now the GP at the lower tier wants to retire, so he decides to sell the asset. The buyer agrees to pay $19,000,000 for the complex. The proceeds from the sale after closing costs are $18,000,000. The remaining balance on the note is $2,000,000. This leaves $16,000,000 left over. The partnership agreement states that the GP gets half of the net remaining balance. Thus, the limited partnership (the upper tier) gets a check for $8,000,000.
The Limited Partnership (the upper tier) states that the GP gets the first $500,000 at termination of the partnership and any balance is paid out to ALL the partners based on their ownership position. This means that $7,500,000 is paid out to the partners. The GP gets 1% or $75,000 and the limited partners split $7,425,000. Each receives $825,000.
Therefore, the limited investor puts up $300,000, earns $75,000 over 15 years and gets a termination check for $825,000.
Total Cash Out: $300,000
Total Cash In: $900,000
Return on the Investment is approximately 7.8% per year.
This is how the financial arrangement works in most of these syndicated deals. By pooling together a group of investors, an apartment or office complex is built and all the parties involved win. This is the power of real estate syndication. Act on Knowledge.