A common question from people exploring syndication for the first time is, “if this deal is so good, why doesn’t the sponsor keep it to themselves?” It is a very natural question, but misses the point of why someone is syndicating in the first place.
Fundamentally, syndicators come from the perspective that they would rather have a smaller piece of a huge pie than a huge piece of a much smaller pie. No matter how much money a sponsor starts out with, eventually, they will run out of it if they keep investing just their own funds. At that point, they reach the limit of their ability to scale. By creating a syndication, they can leverage their expertise and time investment to increase their cash flow and help their investors at the same time. And, by investing in their own deals, they still get to share in the upside.
Let’s take a simple example. Say a sponsor has $1M to invest in real estate. If they are investing in a moderate priced area with a median home price of $200k, they could buy 5 homes free and clear. More typically, they would take out a mortgage and be able to buy $4M worth of real estate, or 20 homes. If each home then brought in $200/month in positive cash flow (after taking into account all costs including maintenance and vacancy), they would be getting $4k/month, or $48k/yr, which is pretty good. However, having exhausted their own funds, that is as big as they could get (not counting small incremental additions if they reinvested all of their positive cash flow over time).
However, instead, they could develop a syndication deal. Working with 40 of their friends and acquaintances each putting in $100k, they could have a total of $5M to invest. Being conservative, they don’t take on any debt but purchase a property that will provide a 6% cap rate. That would generate approximately $300k/yr and, since the sponsor put in 20% of the funds, they would get $60k/yr for the same $1M investment. If they are able to find a property that has a 7% cap rate, they would be able to get $70k/yr instead. If they are able to find a loan at an interest rate less than the cap rate, they could buy a larger property and increase the cash flow even more. And if they have the opportunity to renovate the property, that would increase cash flow, and ultimately their IRR, even more.
The sponsor would also generate income from his active engagement in the deal – usually as a 1%-3% fee for managing the syndication and as part of the waterfall after the preferred return has been paid out. This additional income is used to both pay business expenses, but also compensates them for their time. That compensation can then be used to invest in other deals.
By “growing the pie”, in other words pooling resources to make bigger deals, the sponsor is able to both increase their own returns and help other people (their 40 friends in this example) get the benefits from REI as well. When done well, this is truly a win-win scenario for everyone.
Now, if the sponsor didn’t bring a good deal to their investors, the investors would not provide the money to close on the deal. They would put their money elsewhere. Without the investor’s, the deal doesn’t happen and the sponsor can’t invest alone. So, the sponsor is incentivized to bring good deals to their investors in order to get them engaged and grow the pie for everyone.
Yes, this is a simplified example, since it doesn’t take into account the other costs that the syndication would incur, or the potential for a value add opportunity, but it is a reasonable example that shows how by working together, both the sponsor and the investors win.
If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.
This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.