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To invest in real estate passively or not. My experience.

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Before we begin... a big thank you to this week's sponsor - RealMarkets

Foreclosure Auction

May 16, 2024 @ 12pm EST
  • 2000 Duke St, Alexandria, VA - 164,407 SF Office Building

  • Sold Subject to Ground Lease, Located at the Gateway to Carlyle District Old Town Alexandria

  • Sells to Highest Bidder Above $500,000 / Last Traded for $57.75MM in 2019

Let’s get to it.

Like most things, getting into real estate syndications is simple but not easy. I’ve been analyzing syndications for a few years now and learned a lot of lessons, many of them the hard way. Why I wanted to share the experience so you hopefully save yourself the trouble.

You may be thinking, why go for real estate syndications?

Being a passive limited partner in other deals opens you up to various asset classes. It’s a great way to reap tax benefits, one of the best avenues investors have in terms of maximizing tax savings. Not to mention, it gives you a passive way to profit from real estate.

But it’s not all rainbows and butterflies. Before diving headfirst into syndication deals, you must consider some potential pitfalls.

In this newsletter, I’m going to share my experience. Lessons I’ve learned from working with a diverse group of sponsors across varied product types and geographical markets throughout the US.

We’ll talk about the highs and lows and a few pointers you might want to mull over before diving in.

Let’s talk straight about the benefits first. A standout one?

The tax treatment you get with direct commercial real estate ownership.

I’m not giving tax advice here, and every situation is unique. But, generally, when you invest in a syndication, you become a part of a group owning a commercial property. You get a direct ownership slice. That means you get the tax perks that come with property ownership.

As an owner of commercial real estate, you can subtract depreciation expenses from your share of the income that the property generates. That’s a huge perk of investing in syndications. It’s even more of a benefit since the Tax Cuts and Jobs Act was passed in 2017.

The Tax Cuts and Jobs Act brought in a sweet deal for real estate owners - bonus depreciation. This allowed investors to depreciate up to 100% of a property’s components with a five, seven, or 15-year lifespan in the first year of ownership.

Sure, this benefit is now being reduced, in 20% increments, starting 2023. But it’s still a massive plus for investors looking to lighten their tax load.

The value distribution between the land and the building being bought can significantly influence this. You might end up with a hefty paper loss in the first year of ownership. This loss can be so significant that it often surpasses the property’s taxable income before depreciation is deducted.

What’s the outcome? You might see your distributions from operating cash flow being entirely tax-free. Plus, there could be considerable carryover losses that can offset future income generated throughout the ownership period.

Besides the tax benefits of putting your money in syndications, there’s another thing I really like. When you invest directly in individual deals, rather than in REIT stock or a discretionary fund, you get to pick and choose. You can handpick the investments that you believe in the most.

When you purchase public REIT stock, you’re essentially getting a slice of a whole operating company. That could be brilliant for diversifying your portfolio. But here’s the catch: you’re also saying ‘yes’ to every single property the company holds in their portfolio.

But here’s where syndications shine. When you directly invest in them, you can restrict your investments to specific product types and geographical markets you truly believe in. You can even choose business plans that you feel most comfortable with.

Let’s say you only want to invest in stabilized industrial properties in the southeast United States. Syndications let you do exactly that.

This turns out to be a massive advantage for investors who have a solid hunch or conviction about the market’s direction. They can place big bets to maximize potential upside. Plus, this also lets investors steer clear of other industry sectors they believe might be going downhill, reducing their exposure to these areas.

Tax benefits and the power to select your deals are both giant pluses. But there’s another big benefit when investing in syndications. Unlike other forms of direct real estate ownership, this is truly a passive investment.

You’ll partially own a company. You’ll get to enjoy the tax benefits that come with direct ownership. But as a limited partner, you won’t have to deal with acquiring, managing, or selling your deals.

Especially if you’re already knee-deep in a career you love. If you don’t have the time or the inclination to spend your nights and weekends chattering with brokers or walking through properties. Going the passive investing way could be an excellent strategy to build your portfolio. And the returns can actually be bigger if you lack the experience being an operator yourself.

Partnering up with a group also has an added bonus. You get to invest in bigger, institutionally managed deals. These can often noticeably cut down the risk tied to your investments. Plus, it tends to broaden your potential buyer pool under different market conditions.

Despite the many upsides, there are also significant downsides to consider. The first one on the list? As a passive limited partner, you’re going to fork out for fees and promoted interest. These create a drag on your returns.

As a passive investor, fees pop up at nearly every turn of the investment cycle. Be it an acquisition fee when the property is first bought, an asset management fee throughout the ownership period, a construction management fee during a renovation, or a disposition fee when the property is sold.

Investors in syndications typically forfeit a substantial portion of their profits, assuming the sponsor surpasses a predetermined preferred rate of return. This can significantly impact LP distributions when it’s time to exit the deal.

From my POV, considering all the fees and promoted interest paid to the sponsor (or the active partner on the deal), with project level returns on a deal in the high teens (so, between about a 14 and 18 percent IRR), the drag on LP returns is typically around 200 to 400 basis points.

This means that if the investment at the project level earns 16 IRR, the limited partners on the deal usually see returns between about 12 and 14 IRR on their equity investment.

While there’s a significant drop from project-level returns, if you step back and compare these returns with other passive investment vehicles - ones with similar risk profiles but often less favorable tax treatment - a 12 to 14 percent annualized return is still an impressive performance. Especially when you consider a five, seven, or ten-year period.

So, while it may sting a bit to give up a few percentage points to the active partner on a deal, this drag feels a lot less significant when compared to other market options.

But fees and promoted interest aside, another significant downside is the lack of control over your syndication investments. This can make planning from various perspectives quite challenging.

As a passive limited partner, you won’t be controlling the quantity or timing of operating cash flow distributions you’ll receive. You won’t have a voice in refinancing decisions when an acquisition loan eventually matures. You also won’t be able to control the timing of a sale, regardless of your personal circumstances.

These factors can become issues if you depend on your real estate portfolio to fund your lifestyle or retirement since distributions can shift rapidly due to market conditions. This can also pose a problem in tax optimization if you’re aiming to minimize capital gains when a property is sold.

In my opinion, this is likely the biggest downside of going this route. If you have a unique tax situation and you want full control over your investments and when you choose to exit your deals, you might want to reconsider LP investing.

The final downside I want to mention might seem somewhat insignificant, but as your portfolio grows over time, it can become a significant issue. This is the timing and the cost associated with filing taxes for these investments, which can become burdensome in several ways.

By directly investing in a real estate partnership, you’ll generally receive a form K1 at the end of each year for each deal you invest in. These forms are required for filing your tax returns.

However, the timing of when you actually receive these completed K1s can vary significantly from partnership to partnership. Since business taxes generally aren’t filed until mid-March each year, this often results in your personal tax return either coming down to the wire or necessitating an extension.

Some tax professionals calculate your tax prep fees based on the number of K1s you must file. This can sometimes make these costs surpass the actual distributions you’ll receive from some of your investments, especially on deals where you’ve cut smaller equity checks in the five to ten thousand dollar range.

Your personal tax situation can also start to become quite complex when you’re investing in properties in different states. This requires you to file multiple state tax returns, regardless of the location of your primary residence. This can, once again, increase your tax prep cost and add complexity to your personal tax returns.

Overall, there’s a lot to consider before investing in syndications.

But if you’re seeking a way to invest in real estate that’s hands-off, allows you to handpick the specific deals you want in your portfolio, and lets you participate in the tax benefits that come with direct property ownership, investing as a passive limited partner is certainly worth considering.

For the past year, I have had many people reach out looking to invest in my deals, but I am not raising capital beyond my close network yet. However, I am starting to put together a proof of concept for a marketplace where I could connect vetted operators with passive investors.

If you fall in either of the categories, here is a page to indicate your interest.

Cheers,

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