ForeclosuresMass - ForeclosuresMass Monthly - Feature - How Real Estate Investors Make Big Money with Syndication (June 2008)

If you've been in real estate awhile, you've probably already figured out that buying and flipping properties, or holding them long-term in order to generate passive income, will certainly net you profit - but not the kind of stratospheric profit you hear the gurus talk about.

And, too, you may have a certain amount of liquidity, but not the sort of cash that will allow you to purchase a million dollar property - let alone a $10 million dollar apartment building.

If you've been wondering how people become very, very successful in real estate, we have a "secret" to tell you - they do it through a not-so-secret process called "syndication."

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Real estate syndication refers to the process of finding investors who have serious cash and who want to invest in a real estate deal - without having to deal with the headaches of managing the property.

The process is akin to buying your first home for $150K. Let's say you had to come up with $30K for the down-payment. You had $20K through hard saving, but needed another $10K, so you went to your parents, or maybe a rich uncle, who lent you the money. In effect, this is an informal syndication.

A real estate investor who wants to purchase a $10 million dollar property is in the same position as the person buying a starter home. He or she doesn't have the $2 million for the down-payment (or they may have it but they want to spread the risk), so the real estate investor has to bring in other investors. On a deal needing a $2 million down-payment, for example, the real estate investor might bring in 20 people with $100K each in cash in order to fund the deal.

In a nutshell, this is syndication - and doesn't it sound easy? Just find other people's money and you, too, can be on the road to real estate riches.

Cool your jets, people. Syndication, while a powerful tool, is also a complicated process. Although not intended to be a complete description, I have attempted to outline the basics below.

A group of people who put together a syndication do not operate under a "handshake agreement." Typically, most syndications fall into one of two types of formal business structures: a Limited Liability Corporation (LLC) or a Limited Partnership (LP). LPs were huge 10 to 15 years ago but you don't see too many of them anymore.

These businesses must adhere to strict SEC (Security and Exchange Commission) rules and regulations outlined in formal documents drafted by an SEC attorney. Why is this?

Real estate syndications are seen as securities under the law, and as such all actions and transactions on the part of the LLC or LP must be done according to very specific SEC rules, including but not limited to: the real estate deal has to be offered to investors in a specific way, investors have to meet certain criteria, specific disclosures must be made, and investors have to invest at specific times.

Run afoul of the SEC rules in your syndication documents or your procedures and your investors can force you to give back their money, reimburse them for any losses, and subject you to penalties - definitely not a good thing.

The one thing that the syndication documents establish is the classification of participants - the passive investors contributing the money and the Managing Member (for the LLC) or the General Partner (for the LP). These documents also define the distribution of cash flow, tax benefits, and future potential profits when the property is sold.

The Managing Member or General Partner is in charge of managing everything - from finding investors to overseeing all transactions and paperwork. He or she has the rights and responsibilities of raising funds, purchasing the property, and managing the property. If the investors are unhappy with the performance of the deal, the Managing Member can be voted out of a job by investors within the group.

A Managing Member may be an investor in the property - although this isn't always the case. Some Managing Members may bring "sweat equity" to the table, meaning they find the deal and they manage it from start to finish. Their investment is the work they perform.

If you're asked to invest in a syndication deal, it's imperative you research the Managing Member's business and real estate experience, especially with regard to previous syndication deals. Questions to consider include:

Your Uncle Frank may be able to plunk down $10K to help you with the down payment in cash on that two-family, but this doesn't necessarily make him the right kind of investor for a syndication deal.

The SEC makes a distinction between people with a lot of money versus people they consider as having a little bit of money.

Although anyone can invest in a syndication, you, as the Managing Member, need to be aware of the distinction made by the SEC. The SEC maintains that people with a lot of money know quite a bit about investing and classifies them as "accredited" (not necessarily the case in real life).

An Accredited Investor is a person with $1 million of net worth (not necessarily liquid - assets are ok), OR with an income of $200,000 per year if the investor is single or $300,000 per year combined income if married. The Accredited Investor must sign a form stating that he or she meets these net worth or income requirements.

The SEC considers that people with high net worth or income have a different perspective when it comes to investing. Because they deal with larger sums of money, high net worth people tend to be more sophisticated about investments and better understand the concept of risk, return, change in business, etc. They're also able to ride out the ups and downs of long-term investments - whereas people with less money would have a much harder time.

In addition, when you deal only with Accredited Investors, the SEC has fewer requirements for the syndication and fewer demands for the disclosures to the investors than when you accept non-accredited, less sophisticated investors. If your syndication accepts investments from non-accredited investors, the disclosures are even more extensive, the documents more complicated, the process of setting up the syndication takes longer, and the legal fees are much more expensive!

Because it's so highly regulated, a real estate syndication deal can feel less risky than some other types of investments. However, don't let the rules and regulations lull you into a false sense of security: syndications can be risky. The risk is based on the underlying investment made by the syndication. If the LLC buys a great property, in a great location at a great price and it's managed well, the risk is reduced. Risks increase when a property is poorly maintained and mismanaged.

Money invested in a syndication is not usually liquid. Often it's tied up for three to five years. You simply will not be able to call the Managing Member six months into the deal and ask for your money because you need it for something else.

And, because it's a business, a syndication deal is subject to market and economic turbulence just like any other business - which means things can go down before they go up.

As the Managing Member, do not take shortcuts. Do not download "fill-in-the-blank" SEC documents from the Internet because the regulations are serious and complicated. You have to hire a good SEC attorney and accountant who understand real estate syndications.

And finally, if you're the Managing Member, you're ultimately responsible. If, for example, returns are lower than promised, you need to take responsibility and report to your investors. Bad news should be reported quickly. You need to tell them the facts and circumstances that resulted in the reduced performance and the corrective action you're taking.

Despite the risks, syndication is a powerful way to grow your profits and your skill set. If you're considering syndication, the questions you want to ask yourself include:

My husband and I are part of a number of syndications. My husband is a registered architect and one of my businesses is a financial services company. We have spent close to two decades investing money in real estate on behalf of my clients. Syndication has been a real learning curve for us.

We recommend that if you've achieved some success as a real estate investor, and you're seriously considering syndication, that you become a partner in a syndication or two before you do one on your own.

We also recommend you do lots of networking - because many of these deals happen between people who know and trust each other. Attend Real Estate Investors Association (REIA) meetings and educational seminars and become a member of a mastermind group. Build up your network, find your attorney and accountant, and become a partner on a deal. You'll then be on the right track to making the serious money the real estate gurus promise you'll make.

Eileen Schwartz is a fulltime real estate investor and financial planner. The owner of six businesses, she works out of a "real" bricks and mortar office in Newton, Massachusetts. She can be reached by phone at 617-332-3535or by email at eschwartz@esscoweb.com.

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