Syndications: Everything You Need to Know BEFORE You Invest

Mindy:
Welcome to the BiggerPockets Money Podcast, show number 219, Investment Deep Dive, where we talked to the all-knowing J Scott about real estate syndications.

J Scott:
And so, a good investor doesn’t think of a syndication as a purely passive opportunity. They think of it as a hell of a lot of work until the minute they hand over the money, and then it becomes a purely passive deal.

Mindy:
Hello, hello, hello. My name is Mindy Jensen, and with me as always is my consistent cohost Scott Trench.

Scott:
You always have a new one every single day, Mindy. Really appreciate it.

Mindy:
Scott and I are here to make financial independence less scary, less just for somebody else, to introduce you to every way to invest, because we truly believe financial freedom is attainable for everyone no matter when or where or how you’re starting.

Scott:
That’s right. Whether you want to retire early and travel the world, go on to make big time investments in assets like real estate syndications, or start your own business, we’ll help you reach your financial goals and get money out of the way so you can launch yourself towards those dreams.

Mindy:
Okay, today we have an epic episode with the J Scott. He comes in to talk to us about all things real estate syndications. If you are thinking about investing in syndications, which is a great way to passively invest in real estate, this episode cannot be missed. J comes in and gives us just an overwhelming amount of knowledge about the process. And more importantly, near the end, he gives us a list of questions that we should ask before giving somebody our money.

Scott:
Yeah, I have a couple of key overview points that I think will help you as you’re entering in this episode. First is that to invest in syndications usually, not always, but usually, you need to be an accredited investor. Right? Even if you can qualify as an accredited investor through some means like the new ones that the SEC has been introducing, the minimums to invest in syndications are typically $50,000 to a hundred thousand dollars, although you can get away from time to time with $25,000 minimums, sometimes a little smaller. But you should expect it to need to come up with that type of money per investment.
So, this is a little bit more of an advanced episode. You’re going to hear a lot of jargon. Right? We’re going to talk about cap rates, net operating income, preferred versus common equity, carried interest, all of these different types of things that are necessary to the discussion of syndication, to the language of syndications with this kind of stuff. And this is meant to be a pretty deep, but still cursory, high-level overview of getting into this world and what to expect that’s needed.
The advantage, of course, is that this is a great way to parlay your experience. Let’s say you’re a real estate investor who listens to BiggerPockets Money and our real estate podcast and have a couple of properties. You’ve already put in a lot of education around the real estate space, and that might be a relatively small leap to that next level of investing in these types of syndications.
And that’s what I do. I think it’s a perfect avenue for somebody who’s willing to invest those minimums at some sort of periodic cadence once every year or two, or once or twice or three times a year in syndications, that you can vet where you feel comfortable being able to vet the operator, vet the market, vet the deal, vet the business plan and all that kind of stuff.
It’s an education, but I think you’ve got a chance to earn a little bit more than the 10% long-term average that an index fund might present without all of the work and operating the investment that comes with real estate. So, that’s the backdrop. I hope you’ll enjoy this episode. I thought it was fascinating. And J Scott is just a master with a lot of these concepts, and I think really dropped some knowledge bombs in the show.

Mindy:
J Scott, welcome back to the BiggerPockets Money Podcast. It is always such a delight to talk to you.

J Scott:
Oh, I am thrilled to be back. I love this place.

Mindy:
Oh, that’s so nice to hear. Okay, so J, as you may remember, joined us first on episode 43, and then again on episode 70. And today, J is here to help us take a deep dive into the concept of real estate syndications. J, I am so glad you’re here. Because when I think of J Scott, I think of knows everything. J Scott knows everything. I don’t know if you’ve ever thought of changing your name to that, but…

J Scott:
No, I think my wife would probably disagree with that, also, but I appreciate people thinking that.

Mindy:
So, let’s jump right into this because we have a lot to unpack today. What is a real estate syndication?

J Scott:
Yeah. So, a syndication’s really just a fancy term for a very specific type of real estate partnership. Now we’re all familiar with basic real estate partnerships. Maybe you’ve done a flipping partnership, anybody out there that’s flipped houses, where you typically have one or two people that are doing all the work. They find the deal, they renovate it, they resell it. And then for money, they perhaps bring in somebody else who provides some or all of the money for the deal. And in return for bringing the money, that investor gets a percentage of the profit. They’re what’s called an equity partner.
Well, a real estate syndication, or any syndication, basically just takes that simple partnership model to the next level. And while this isn’t the formal legal definition of it, when we talk about a syndication as a partnership, we’re typically thinking of three things that differentiate a syndication from that simple partnership that I just described.
So, number one, typically we have more than one person who’s providing the money. There could be 10 or 20 or even a hundred investors in one syndication deal. And we often refer to them as pooling their funds. You can’t tell one person’s money from another person’s money. All goes into one pool, and it’s used to fund that particular deal.
Number two, most or even all of the people that are providing money for the syndication are completely hands off. They’re purely passive investors. They have no control over the deal. They have essentially no voting rights. Maybe in certain very specific situations they may get some say, but for the most part they’re completely passive.
And the number three, those passive investors who are providing the money get some type of equity stake in the partnership. They get some percentage of ownership in the deal. They share in the profit and losses. They’re not just a lender in the deal.
So, when you put those three things together, more than one person providing money, those people being passive investors in the deal, and them getting a percentage ownership as opposed to just being lenders on the deal. When you put those three things together, it takes a partnership to a syndication.
And again, I’m not an attorney. I’m certainly not a syndications or a securities attorney. But a good rule of thumb is that any time you pool money from passive investors, multiple passive investors, you’re treading into SEC territory. And that’s why most syndications, you’re going to see that there’s going to be a lot of red tape, there’s going to be reams of legal documents, and in general, there’s just going to be a whole lot more scrutiny and formality than with a typical partnership.
And because of all the extra red tape and all the extra formality, as you can probably guess, syndications typically encompass really large deals. They can cost $20,000, $30,000, $40,000 or more to bring in the attorneys and the accountants and everybody else necessary to put together a syndication. And typically that’s only going to make sense when the deal you’re doing requires a raise of millions of dollars and profits of hundreds of thousands or potentially millions of dollars as well.

Scott:
J, the term syndication I think has a pretty broad definition. I love your definition. We’re going to define it as that. But if you’re listening, you may hear the word syndication applied to things that aren’t even real estate deals. Right? That are, that are completely out there, and business deals or foreign ventures or whatever it is. Right? But we’re calling a real estate syndication, your definition is pooling together of private individuals, some kind of ownership stake, and some sort of passivity. Did I get those three right?

J Scott:
Yeah, exactly. So, multiple investors pooling their money, being passive in the deal, having no voting rights or control, and getting an equity stake sharing in the profits and losses for their investment.

Scott:
With this kind of investing, why is it uncommon? Why don’t I hear about it more as an everyday investor, someone getting started in my wealth building journey?

J Scott:
Well, it’s funny, because I think once you hear the term, it’s just like anything else. Once you hear the term and you start looking for it, you’re going to start hearing it everywhere. And like you mentioned, it’s not just real estate where we see syndications. In the business investing world, I do some angel investing. And so, a lot of times I’ll invest in businesses with a bunch of other people passively in a syndication model.
I owned some race horses. I’ve invested in race horse syndications where somebody wants to buy a million dollar race horse. They don’t have the money. So, they might bring together 20 people with $50,000 each to passively invest in a race horse. So, syndications really span all different asset classes. But as a real estate investor, and just in general, real estate syndications tend to be the ones that are most talked about.
Now why we don’t hear more about them. The big reason is there are some hurdles to investing in syndications. The big one is that for most real estate syndications, the investors need to be what’s called accredited. And what accredited means, that’s a legal term that the SEC has defined as having a million dollar net worth, not including your personal residence, or making $200,000 per year, or if you’re married filing jointly, $300,000 a year.
So, another term for that is loosely called a high net worth individual. You have a lot of money or you make a lot of income. You need to meet that criteria to invest in a lot of syndications. Because with a lot of syndications, the way they deal with all the legal red tape is they register with the SEC. And that’s just one of the requirements for many syndications, not all of them, but a lot of them. Secondly… Yeah.

Scott:
If I’m on that income front, if I’m a real estate investor, I would say make $150,000 a year, and I have a rental property that brings in $50,000 in rent per year, but only $5,000 or $10,000 in cashflow, do I meet the $200,000 mark?

J Scott:
So, it’s typically, I forget what line it is on the 1040, but it’s your adjusted gross income. So, it’s your AGI. So, if you look on your 1040 tax return, find that line on the middle of the first page called AGI or adjusted gross income, and that’s the number I believe that’s looked at. And typically what they want to see is that you’ve hit that $200,000 or $300,000 target for each of the last two years, and you expect to hit that target moving forward.

Scott:
If I want to invest in a syndication and I’m close, who’s checking?

J Scott:
Typically, the syndicators themselves are going to make sure that there is a third party that says you are accredited. Because there’s legal liability if a syndicator takes an investment from somebody later finds out that they’re not accredited, that person sues the syndication. So, typically you’re going to be looking for a third-party authenticator, two people that essentially have the authority to do that, attorneys and CPAs.
So, you can go to your attorney and basically provide them your list of assets or your tax returns and say, “Can you write me a letter saying I’m accredited.” You can go to your CPA and you can do that. Or there are websites online where you can essentially do the same thing. They have third-party attorneys and CPAs who will take your information. They may ask you more questions. They may ask you to provide documentation and appraisals and other stuff.
But you can go through the entire process online. They’ll certify you as accredited or not. Typically, if you’re not really close and you can prove it easily, it’s a couple-hour process. And then they’ll give you a signed letter that you can then hand over when you’re investing in the syndication, they’ll typically ask for it, saying you are accredited, and that letter is good for some period of time.

Scott:
So, you really shouldn’t be accredited if you want to get into this, and it’s going to be a little hard to sneak past if you’re not.

J Scott:
Absolutely. There may be some syndicators out there that don’t force you to cross your T’s and dot your I’s. But I would typically think that if they’re cutting corners there, where else are they cutting corners? So, I would generally recommend, get that letter, make sure that you are accredited before you try and invest in a syndication.

Scott:
Okay, so I am an accredited investor. I have decided that I’m interested in exploring further. Where do I even begin to find syndicators outside of maybe a Google search with this? How do I even begin the process of finding people who put these together?

J Scott:
Well, again, it’s funny. Once you start looking for it, you start to see it in a lot more places than you would expect. So, obviously be part of the BiggerPockets community and BiggerPockets network. Lot of people in the BiggerPockets world who do syndications, both from the operator side, they actually actively start and run syndications, and the investing side. Be active on the Facebook group, be active on the BiggerPockets forums. And then start attending local real estate meetups. You’re going to find a lot of people who are doing big deals in those groups, again, from both sides, whether they’re being active as the syndicator or they’re investors in these deals. And they’ll start bringing you these deals.
Now syndications occur across all different niches and asset classes. You can find syndicators that are doing deals in the residential space, both single-family and multi-family. Brandon Turner has syndications in the mobile home space. You can find them in self storage. You can find them in commercial, office, warehouse, industrial, everywhere.
So, if there’s a particular type of syndication, a specific asset class or niche that you’re looking for, start seeking out big operators in those areas. And again, you can do a Google search, but you can also go onto BiggerPockets and just look in the forums specific to those areas, and you’re likely to find out about the operators that are doing those types of deals.

Mindy:
Okay, before we get too far away from where I have several questions, you mentioned SEC a couple of times. And when I hear SEC, I hear scary regulatory agency. Do I as the accredited investor who wants to invest in a syndication, do I need to be concerned about SEC stuff? Is there an easy way to make sure that person that I am considering doing a syndication with has gone through this and covered it? Because I never want to get on the wrong side of the SEC.

J Scott:
Yeah. So, there are a whole bunch of questions, and we can go into those at some point, that you should be asking the people that you’re investing with. And one of those is have you registered this syndication correctly with the SEC and are you doing everything legally?
Now, let me jump into the bigger question, which is do you have liability as an investor if you do something wrong, or if the syndicator or the person running the syndication, if they do something wrong. Certainly the SEC is some big, scary government entity. And as a syndicator myself, I am very serious about making sure that everything we do is within the scope of the law and is done correctly. And for the most part, every other syndicator I know does the same thing.
The nice thing is, if structured correctly, as an investor in a syndication, and again, assuming it’s structured correctly, you should have no legal liability. That’s actually one of the big benefits of investing in syndications is that there is no liability for the investors themselves.
Now we as the syndicators, the people running the deal, they have some liability. If they do something that’s grossly negligent, if they do something that’s fraudulent, if they do something… if they take money without verifying the accreditation status of their investors, yeah, they can face a lot of penalties. But the nice thing is, again, when structured correctly, and typically the correct structure is what we refer to as a limited partnership, the investors have formally no liability, legal liability, just being an investor.

Mindy:
Okay.

Scott:
This is why we should all aspire to the eventual title of limited partner. That’s the end state.

J Scott:
Hundred percent. Yeah, and just to explain [crosstalk 00:16:50].

Scott:
You climb the corporate ladder until you’re there. That’s it.

J Scott:
Yep. And just to explain to people what that means when you use the term limited partner. Typically, not always, but typically the way these syndications are structured, you set up what’s called a limited partnership. And for those familiar with an LLC as a business structure, this is a different type of business structure where the business is broken up into general partners and limited partners. And typically the general partners are the active ones in the deal. They’re the ones that have all the control, they have the voting rights, they make the day-to-day decisions, and they have the legal liability for anything bad that happens.
And then on the other side are the limited partners. These are people that can put in money into the deal, they can get an equity share, they can own part of the business and whatever the business owns. But they’re completely passive. They have very few, if any, voting rights. They have limited, if any, control. And as part of being a limited partner, in a limited partnership, these investors have no legal liability. So, you’ll often hear the terms general partner or GP, that’s the people running the syndication, or limited partner or LP, and that’s just the people investing in the syndication. Just different terms that you often hear.

Scott:
J, let’s put together a fake deal real quick, just high level with this. I’m buying, and I’m a general partner or I’m an accredited investor, and I’m looking to partner with somebody or invest in somebody who’s buying an apartment complex. Let’s call it a $15 million apartment complex. I got to put two-and-a-half to five into rehab it and fix it up, that kind of stuff.

J Scott:
So, let’s use five million to put into it. So, let’s say you’re buying it for $15 million. It’s going to cost you a million dollars in inspections and appraisals and all the closing stuff, so that’s $16 million. And then going to cost you four million dollars to renovate the property. So, $20 million is your all-in cost. That’ll allow you to buy it, to close on it, to do all your due diligence, and then to do the renovation on the backend to get it stabilized. So, $20 million.
Typically speaking, you’re going to go out and you’re going to get debt. You’re going to talk to a big lender. It may be Fannie Mae, it may be Freddie Mac, it may be a large bank. And they’re going to provide you somewhere around 70% to 75%, hopefully, of the purchase price in debt. And so, again, $15 million purchase price. Let’s say you get 70% of that in debt. So, 15 times 70 is, what, 10,500,000. Let’s say $11 million you get from Fannie Mae as debt. So, that’s a loan. That’s your first position loan.
So, now you still need to come up with another nine million dollars because, again, $20 million is the total raise to do everything. $11 million is in debt. So, now you have to go find that nine million dollars. You can go out and start a syndication and raise $9 million from accredited investors. You can put in a million yourself and raise eight million from accredited investors. You can find another debt partner and raise a little bit more in debt if you can do that. You might be able to get seller financing. Maybe the seller is willing to hold a note for part of that. But at the end of the day, whatever you’re not getting in debt and you’re not putting in yourself, you’re going to raise some other investors.
So, simple deal here is on a $15 million purchase, billion dollar closing, four million dollars in renovation costs, you might be getting $11 million or $12 million in debt from a Fannie Mae or Freddie Mac or a big bank. And then you’re going to have to go out and find passive investors to fund the other eight million or nine million dollars.

Scott:
How do I structure that with the passive investors?

J Scott:
So, lots of different ways. You will see some commonalities amongst a lot of syndications. But I do want to throw out, any examples I give here aren’t necessarily going to encompass every deal you do. Some syndicators are really creative, and that’s actually a good thing because a lot of these deals can be difficult to put together. And so, being creative allows you to do things that can be a win-win for all sides.
But typically speaking, investors will get some level of what’s called preferred return. So, that means that if you invest, let’s say, a hundred thousand dollars into the deal as a passive investor, you’re going to be promised some amount of return every year before the syndicator, the person that’s running the deal, gets anything. And so six, seven, eight, nine percent is pretty typical. Let’s say eight percent. So, if this deal promises eight percent preferred return to the investors, that means if you put a hundred thousand dollars in, you’re going to get minimum of eight percent return every year, or $8,000 every year, in cashflow before the syndicator gets anything.
Now, what if the deal doesn’t make enough money to give you $8,000 in year one or year two? Well, that money is going to start to accrue. And you’re going to be owed all the back money that you’re due, and you’ll be caught up and you’ll get all that cashflow before the syndicator gets anything. And that’s one of the ways that syndicators do a good job of aligning their interests with their investors. The investors get the money first. And if investors don’t get that minimum eight percent, syndicators don’t get anything. So, there’s that hurdle that a syndicator really wants to get over, and that’s called the preferred return.
Now, once you get past that preferred return, and the investors get some guaranteed percentage, at that point, the rest of the cash flow, as well as when you do a refinance or a sale and you get a big pot of money, that money is then split in some proportion between the syndicators and the passive investors. Typically, it’s not 50/50 like you often see in small real estate partnerships.
Typically, the passive investors are getting the bulk of that money. They might be getting 60% or 70% or 80%, and the syndicators getting 20% or 30% or 40%. So, again, aligning interests between the syndicators and the investors. The syndicators want to get as big of a return as possible, because the first part of the money is going to the investors, and then a very large part of the percentage of the rest is going to the investors. And so, for the syndicators to make a lot of money, the deal has to do very well.

Scott:
Let’s go back for a second here because this is fascinating. I hope if you’re listening, you can tell that we’ve got an entire universe, a new language to learn, new terms to uncover and unpack. And this is an intro, this is going to be an intro, but we can’t help ourselves. We’re going to use the jargon anyways with this, because this is the language of the syndication world with this kind of stuff with pref returns and how that changes over time, investor carry, all those kind of good stuff.
But let’s zoom back out for a second. We just bought this apartment complex for $15 million, a million dollars in closing costs, and we’re going to rehab it for four million dollars. How the deal itself work? How do I make money on that deal absent all the different ways we structure returns or whatever. Just how does the equity owner in general make money on this deal?

J Scott:
So, that’s the cool thing about syndications is there’s no one way. Syndications run the gamut. I mentioned earlier that you have syndications even outside of real estate. So, you have syndications in the business world and all the other worlds. Even within real estate, there are so many ways to structure it, so many different ways you can do a syndication. I already mentioned that it crosses asset classes. So, I can do residential syndication, single family. I can do multifamily, self-storage, commercial, all of that.
Then you can cross syndications across not just asset classes, but strategies. So, I could do a syndication that focuses in the example you gave of the apartment complex, that’s essentially a big flip. So, we’re buying it for $15 million. We’re putting four million dollars in. Hopefully we’re selling it in four, five, six, seven years for maybe $30 million. That’s basically-

Scott:
Let’s quickly walk through the concept of how much we’re going to buy it for and how much we’re going to sell it for using the net operating income as a placeholder in this example just to kind of… Again, we cannot understate the complexity of the universe and the dozens or hundreds of hours that you as a listener are going to need to put in to make an informed decision investing in this. But let’s just stick with an apartment complex because it’s the next logical step from buying a single family rental that I think a lot of us are familiar with.

J Scott:
Yeah, absolutely. So, let’s say we buy this deal. We’re all in for $20 million. Let’s say on day one, the property is the net operating income. And when we say net operating income, that is the amount of money at the end of the year that essentially goes in our pocket, not including what’s referred to as debt surface. So, not including the mortgage payments, the principal and interest on the mortgage. But it’s all the profit minus expenses or the income minus expenses at the end of the year.
So, let’s say we buy this property, and it’s generating $800,000 per year in net operating income. And let’s say we have this thing called a cap rate of five percent. Cap rate is just a multiplier that in the commercial world we use to figure out the value of a property. And the formula is that if you divide the NOI by the cap rate, you get a general value of what the property should be worth.
So, in this case, we have $800,000 in NOI. We divide that by five percent, which is the cap rate in that area for that type of asset. Dividing by five percent, the same as multiplying by 20. So, the value of this property is somewhere around $16 million when we buy it, which makes sense. We bought it for $15 million, we put a million into it, so those numbers reconcile.
Our job now as the person running this deal is to figure out how to get that NOI higher. Because assuming in five years when we go to resell it, assuming the cap rate is still five percent, we still have a 20 times multiplier, if the NOI has gone higher, the value has gone higher. A higher number is going to be worth more than 20 times a lower number.
So, the goal is to get that NOI from $800,000 a year to whatever. Let’s say we want to get it to a $30 million property. We have to get the NOI to $1.5 million per year. 1.5 million divided by five percent or times 20 equals 30 million. So, then we have a $30 million property.
So the question is, how do we get the NOI, the income from the property, from $800,000 a year to $1.5 million a year? There’s two ways to do that. One, you increase the amount of money that the property is earning. And to increase the amount of money in the property is earning, well, how do we raise rents when we buy a single family house or an apartment complex?
Well, we do renovations, and we bring rents up to market rents. Maybe things are below market. The landlord hasn’t raised rents in a while. So, we bring the rents up to where they should be. We renovate the units, we add new amenities, we renovate the exterior, we do better marketing, we put nice security and lights out there so people feel safer. And at the end of the day, now we may have units that are renting instead of $1,200 a year, after we’ve done all this renovation and work, now they’re renting at $1,500 per year. Great. That’s one way of increasing the NOI is by increasing the income, but it’s not the only way. There’s another way of increasing NOI, and that’s lowering expenses.
So, a lot of times we’re buying buildings that are not managed very well. There are landlords who are tired, they’re not very good at it, they’ve gotten stressed out, they don’t live anywhere near the property. So, they’re managing their properties really poorly. Maybe they’re paying too much in utilities. Maybe they haven’t appealed their tax bill and they’re overpaying in taxes. Maybe their property management company is doing a really bad job of keeping tenants and there’s a lot of turnover. Maybe they’re paying too much for a property manager. Whatever it is, if you can go in there and you can lower the expenses, you can increase the net operating income, that amount of money that you have left over at the end of the year.
So, typically speaking, what you want to do when you buy a property that you’re going to sell in four, five, six years is you want to increase the income it’s generating, and you want to reduce the expenses that it cost to operate it. And again, if we can get from $800,000 in let’s call it gross profit at the end of the year when you buy it to $1.5 million per year in gross profit because we’ve been able to increase the rents and decrease the expenses, we’ve now increased the value of that property from maybe $16 million to maybe $30 million. And that’s when we sell the property.
We don’t have to sell it. Again, there’s so many different ways syndications work. We could refinance it and hold it long-term. But a lot of times we’re going to sell that property. We’re going to take that $10 million in profit, plus we probably made cashflow for a couple of years, and we’re going to split that profit and cashflow between the passive investors and us, the people that were running the deal.

Scott:
Thank you. This is awesome. And I think we should just stick with the multifamily analogy throughout this entire discussion, and then let everybody know, hey, you could apply this to mobile home parks, to retail, to commercial, to self storage and all that kind of stuff.

J Scott:
And you can apply it to stabilized assets that are just holding for 20 years. You can apply it to new construction and developments. Yeah.

Scott:
So, a couple of observations I have here. And NOI, net operating income, and cap rate, these are terms you have to become familiar with if you’re interested in doing any type of syndication investing and those types of things. We’ve defined them earlier, but it may take a few spins if you’re listening to really internalize what NOI means, what cap rate means, and that kind of stuff. While we’re here, we’re going to continue to use those as if you’re familiar and just keep rolling.
What I think is interesting about the cap rate discussion here is let’s say that I have… a higher cap rate means I’m getting more cashflow per dollar invested, right? So, a cap rate of 10% means if I buy a million dollar complex, I’m going to get a hundred thousand dollars in cashflow, effectively. And that means that the area is very undesirable. Right? That means that cashflow, it’s very cheap. I can get more cashflow per dollar invested, usually. Or there’s a problem-

J Scott:
Higher cap rate usually means higher risk. So, higher risk ultimately means less desirable, but it could also mean other things. It could just mean an area that’s up and coming. It could mean an area that a big employer just went out of business, and so population growth is dwindling. But generally, higher cap rate means higher risk.

Scott:
Yeah, and that risk may be reflected by both the area or the asset itself, right? If the roof needs to be replaced, you’re going to increase the cap rate there because people are going to want to… they’re going to bake that into the purchase model with that. So, the NOI has to take into account all those kinds of things.
But what I want to point out is let’s say that you have a very low cap rate of five percent or three percent, right? Every dollar of income that you add, every dollar of income jacks up the purchase price that much more, right? So, if you add one dollar of cashflow, you’re increasing your purchase price or the value of the asset by $20 at a five percent cap rate. And as you push it down to a three percent cap rate with a very…

Scott:
… cap rate. And if you push it down to a 3% cap rate with a very upper end asset in a fast growing market, like a Denver or something like that, you turn that leverage crank even more. And so in this case, it’s effectively a leverage multiplier with that. And so it’s just something to think about, that if you’re doing a value add deal in a high cap rate environment, it can almost be harder to add that value or to realize that value in economics for the investors, than it can in a low cap rate environment. What do you think, J?

J Scott:
Yeah. And just to highlight that point, just a funny story. We do investor calls, or not investor calls, we do calls with our property management team and the operating team for all of our properties once a week. And two weeks ago, there was an interesting conversation between my partner, Ashley Wilson, who’s also the asset manager on our properties. Asset manager is basically the person whose job it is to carry out the business plan over three or four or five or 10 years to get the net operating income from where it is to where it needs to go. And she was having a discussion with our property manager of one of our properties. And the property manager was talking about this copy machine.
And there was this copy machine that was onsite in the office when we bought this property last year. And we have another year on the lease of this copy machine and we’re just trying to decide, do we keep the lease on the copy machine? Do we go buy another copy machine? And this is $188 a month, I think it was, in leasing fee for this copy machine. And it’s like, we’re wasting time having this discussion, but then Ashley points out, “Look, $188 a month for this copy machine, plus we’re paying for paper and we’re paying for toner and ink. If we could get rid of the copy machine completely,” and she did the math really quick, it ended up being like $60,000 increase in property value the day you sell. So literally the stupid little copier machine that you wouldn’t think twice about can ultimately mean money in our pockets and the pockets of our investors when we sell in five years or not. And these are the types of things that you hope your team is thinking about, like you said, every dollar. If it’s a five cap property, a 5% cap rate property, that’s a 20 times multiplier, every dollar you add in extra income at the end of the year is worth $20 when you sell that property.

Scott:
Okay. I love it. Going back to our apartment complex, I’ve just purchased it for $16 million. I’m putting $4 million into it. My goal is to drive NOI from 800,000 to 1.5 million over the next five years, and then to sell the property for $30 million. How does that translate to me as the general partner, the person putting together the deal, making money, and how does that translate to the investor making money on this deal?

Mindy:
I’m jumping in here with a question. First of all, you’re taking a $16 million property, and you’re going to sell it in a few years, with of course adding some money, but you’re only adding 4 million. Is it conceivable that Scott could sell this for $30 million, or is this just pie in the sky? And the reason that I asked this is not to question Scott, but to question the sometimes very lofty goals of the syndications that I have read. And I’m like, there’s no way. You’re not going to be able to sell this dollar 50 property for a hundred million dollars in a month by putting in $12. So that’s obviously an exaggeration, but is it possible to add that much value with such little money invested?

Scott:
That’s the skill that we’re trying to develop for you as a listener, is can you believe these numbers with that? And those numbers are influenced by the plans to increase income, reduce expenses, and the way that they structure the deal with preferred equity, common equity and debt, right? All of those things are going to drive the return that you may realize as the limited partner.

J Scott:
Yeah. And I take Mindy’s question to mean, is that real numbers? Like in the real world, can you expect 30 million or did I just pick 30 million out of my butt? And the answer is yes. For a syndication deal, a $30 million resale on a $16 million purchase is very reasonable with $4 million of extra money. This is where that 30 million is coming from, this is where that NOI bump’s coming from. One, it’s coming from the renovations. So certainly $4 million in renovations… For anybody that’s flipped a house out there, it seems crazy to think I can buy a house for a hundred thousand dollars, I can put 30 into it and then sell it for 200. The numbers are basically the same right there. We do this all day. It just seems bigger when we’re talking millions instead of tens of thousands or hundreds of thousands, but the percentages aren’t that much different.
So the money is being made by, the renovations are going to allow you to increase the rent to, like we discussed, better management efficiencies, going to help you lower the operating expenses and the cost of running the property. But also remember over five years, you’re going to see rent growth. And if you’ve picked a good area, you’re going to see population growth, you’re going to see employment growth, you’re going to see wage growth. And that’s why location is just as important as the deal and the team when you’re doing a syndication, because the goal is that you want to pick locations where you’re going to see a natural inflation in rent, which is coming from a natural inflation in wages, which is coming from population growth and new employment and industry moving in. So all of these things put together, yes, you can very realistically see a $30 million resale.
Now keep in mind, that sounds like a huge number. If you work backwards, that $30 million sale might work out to a return for investors of something like, I’m going to use this compounded return metric called IRR or internal rate of return, it could be a compounded return to investors of 15 or 16%. Definitely not shabby. I mean, that’s an amazing return these days, but it’s not like a million percent return. And when you hear buy for 15, sell for 30 in five years, it’s really easy to think, “Okay, that’s ridiculous returns.” You put it down on paper and you realize over five years, and with all these other things like appreciation and inflation factoring in, it’s really somewhere in the 15, 16, 17, 18% returns is typically what you’re going to forecast. So it sounds like huge numbers, but the percentages are actually pretty reasonable.

Mindy:
Just as that is a reasonable assumption from your standpoint, there are also syndicators, I don’t know if you know this, that they may not be so experienced and they have these ridiculous aspirations that, just reading it you can think, not going to happen. How do you separate the really good returns from the never going to happen returns when you are reading through the syndication proposal?

J Scott:
Okay. Well, let’s always start with too good to be true. We all know too good to be true. If you hear a number… And now keep in mind, too good to be true is a relative term. I just threw out 15, 16% returns. There are people out there that literally when I tell them that we can generate 13, 14, 15% returns, which is pretty standard in the syndication market these days, I have a lot of people outside of real estate who look and say, “No, that’s way too good to be true. I’m getting 8% and the stock market cap rates are 5%. When I hear 15%, I think this is a scam.” So, too good to be true is really a relative thought there. But as a real estate investor, look at what other deals are returning. Get familiar. Don’t jump into the first deal you look at. Look at different deals, not just with different teams, but different asset classes, different locations.
So I do deals in one location, other syndicators focus on other locations. Their returns might be higher or lower. Typically higher or lower returns is going to be an indication, again, of risk. So I might be investing in a lower risk area than somebody else or a higher risk area than somebody else. So get familiar with the market, get familiar with what other people are returning, and then you’ll see. If typical multifamily syndication, where we do a buy and resell in five years, if typical returns are 14% and then somebody is offering 30%, well, that should set off red flags. Because it’s very possible that another group is doing a much, much, much better deal, but smart syndicators aren’t ever going to say, “I’m going to give you a 30% return.” For a couple of reasons. One, they know it’s going to set off red flags; and two, it’s natural that people are going to say, “I want to keep more money for myself. If I find an amazing deal, if I can give my investors 16% instead of everybody else giving 14%, and I can make a whole lot more money, I’m probably going to do that versus promising my investors 30% that they’re not even going to believe anyway.” So typically speaking, if you hear ridiculous numbers, the first thing you should be thinking is, “Okay, red flags.”
Number two, just like anything else. Any time, again, I described syndication as basically just a sophisticated partnership. That’s what it is. When you partner with somebody, what’s the first thing you’re going to do when you decide if you’re going to partner with somebody? You don’t ask them what the returns are going to be. If you’re going to set up a partnership with some somebody, the first thing you’re going to look at is the reputation. You’re going to look at your relationship with them. You’re going to look at, maybe you’re going to talk to other people who have worked with them and you’re going to find out, is this somebody I can trust? Nobody goes into a partnership and just says, “If the returns are high enough, I’ll partner with this guy. I don’t care who he is or what he’s done.”
So it’s very important that we don’t start… I mean, when we’re looking at vetting any syndication deal, there are three things we look at. We look at the team, the location and the deal. Too many people start in the other side. They start with the deal and they say, “Tell me what the returns are and I’ll decide if I’m going to do it.” No. Always start with the team. Figure out who you want to invest with, figure out who you don’t want to invest with. That’s one of the great things about syndication is it’s a great diversification strategy. So you shouldn’t just be investing with one syndicator or one type of deal. So do your due diligence on the team first, figure out if it’s somebody you want to work with, if it’s somebody you’re comfortable investing your money with, and then once you get to that point where you say, “This is somebody I’m willing to invest with,” then you can start talking about, what are the returns? What are the risks? What’s the specific deal. What’s the location that it’s in? What’s the history of the team, et cetera?

Scott:
So I guess you just kind of answered it, but I think that is the real barrier to getting into this world is that reputation piece. And so I think maybe we can go one level deeper there. It seems easier, I think, for you and maybe myself, maybe Mindy here, because we’ve been a part of BiggerPockets, I’ve been part of here for seven, eight years. How long have you been with BiggerPockets on the 4Ms, J?

J Scott:
13. 13.

Scott:
13 years. Each of us have posted thousands of times to our forums, countless times in the Facebook groups, interviewed dozens of people, met people at that conference and the local meetups and that kind of stuff. But suppose you’re not there and don’t have that 10 year history with all this stuff on average, across the three of us, how do I go about actually doing this research and beginning down the path to find syndicators, if I’m looking to invest in syndications?

J Scott:
Yeah. So obviously there’s Google. Google is our friend. First thing I would suggest is, type in the name of the person or the name of the person’s company followed by the word reviews and you’ll see if somebody is really sketchy. Now, just because somebody has one or two or five bad reviews doesn’t mean anything, typically people only leave reviews when they’re pissed at somebody, but you will see the difference between the reputable operators and the not reputable operators just by doing a simple Google search. Next, just like anything else, use word of mouth. You wouldn’t hire a contractor that you’ve never met before and that you’ve never heard anything about before without interviewing them or asking around about them. The way I hire contractors is, I find somebody I trust and I say, give me a name of a contractor that I can use. Well, same thing with syndications. Find somebody that you trust and say, “Hey, who have you invested with? What have you heard about this person?”
Also, here’s another really important thing. We often think about syndications, for a lot of these syndication groups, there is one front person in the group. So even on the BiggerPockets world, we have Brian Burke and Praxis Capital. And so when people talk about Praxis Capital, they think Brian Burke. Brandon Turner runs Open Door Capital. When we think about Open Door Capital, we think about Brandon Turner. Dave Van Horn runs PPR. When we think about PPR Note company, we think Dave Van Horn. But here’s the thing. Just like in sports, you need a deep bench when you’re doing these super big deals. And so you may only hear the name Brian Burke or Brandon Turner or Dave Van Horn, but there is a team behind them. And what you’re looking for, is you’re looking for an experienced and a reputable team, not just the front person.
So it’s important that when you’re asking questions, you’re asking who else is on the team, and what have they done, and what is their experience, and how well has this team and how long has this team worked together? Because again, to use the sports analogy, I don’t follow sports that much anymore, but I can promise you, whoever won the NBA championships last year didn’t win because they had one great player. Whoever won the world series last year, didn’t win because they had one great pitcher. Likewise in syndication, these groups aren’t successful because they have one great person. There may be one big name, but there’s a whole team. And so what you’re looking for, is you’re looking for that bench. And you want to ask about who the other people on the team are.
For any syndication deal, we have a lot of different roles. We have the acquisitions people, the people that are looking for the deals. We have the people doing the due diligence, who are often not the people finding the deals. These are the people that are going in and walking the property and looking at every unit and doing forensic analysis of the leases to make sure that the seller isn’t forging leases, and they’re figuring out how much it’s going to cost to renovate. And then there’s somebody else whose job it is to do the asset management and actually carry out the business plan. There’s somebody else whose job it is to raise the money, whether it’s the equity and the investors or working with Fannie Mae and Freddie Mac to raise the loans. And so there are all these people on the team, and in any good syndication team, you’re going to see the best of the best in each of these roles. Even if there’s one person that kind of fronts the company and you think about as, “Okay, he’s the Brandon Turner at ODC,” there’s still going to be a lot of great people behind him, if that team’s going to be successful. So make sure when you’re looking at reputation, when you’re doing investigations, when you’re asking for references, make sure you’re not just looking at that main person, but look at the people behind them.
Likewise, you want to see redundancy. So you want to know that if Brandon Turner gets hit by a bus tomorrow, well, hopefully there’s somebody else at his fund, at his syndication company, that can take over. And he has somebody, he’s got a guy named Brian Murray who’s been doing this for a really long time. So there’s redundancy there. Another big thing you want to look for, is you want to look for people in teams that have done things end to end. Too often in the syndication world, we focus so much on finding a great deal and the returns on a deal that we don’t ask people, “Well, have you actually taken a deal like this before and seen it all the way through?” When I get on an airplane and we take off, I don’t start clapping as soon as we get in the air. I wait until we’ve landed and I know it’s been a successful flight before I’m really happy. Same thing with syndications. You can have somebody that’s bought 50 properties in the last five years, doesn’t mean they’re a good syndicator. It just means they bought 50 properties. I want to see somebody that’s finished up a few of those properties successfully. So ask about that full lifecycle track record. Scott, you look like you’re about to ask something.

Scott:
Yeah. Well, I just want to chime in. At BP Money, we’re all a bunch of index fund investors, real estate [inaudible 00:48:41] as well with that. And the reason I invest in index funds as opposed to actively managed mutual funds or picking stocks is because I believe that the market is reasonably efficient, and it’s going to be very difficult to sustain out performance with that approach, right? And I believe that index funds are a better way than trying to pick a fund manager. And so the reason… I bet you can kind of see where I’m going with this, right? So when I enter into the syndications world, why do I do that? Why am I interested in investing my own money in syndications? And I do. It’s because I believe that the returns in the syndications world, if I can get a 10% long-term return on stocks, give or take, over a 30, 50 year period, I can get a little bit more than that in the syndications world, in good markets and those types of things, while win some, lose some that kind of stuff.
And I believe that there is enough inefficiency in the syndications world for me to go out there and find a good operator that can give me that 15, 16% return, maybe a little bit more sometimes, maybe a little less some other times, and get that slightly better return here. So I want to pose you with a tough question. We just named all these great folks. And who’s great in the world of active fund management, the guy who was great last year may not be so great the next year, right? Warren Buffet said, “If you have a coin flipping contest, you have a hundred people flip coins, at the end of it or at the hundred thousand, 10 of them will have got the correct coin flip every single time.” How do you actually know you’ve got the great operator after all of that? It’s by asking these types of questions, looking at it. Not looking at just the track record of prior performance, which can be misleading in this context, but asking the deep, detailed questions you have here. How good is your bench right now? What’s the good investment right now that you’re contemplating? How’s that going to work? Is your cost structure with this great bench going to leach return out from my deal versus the guy who’s up and coming and really hungry with all this kind of things?
But that’s why I think this is a really interesting asset classes because all of these inefficiencies exist right now, and nobody knows, really, I think, how to vet the deals. I talked to syndicators and they’re like, “Oh, you’re one of the few people who actually understood this deal and this concept of the low cap rate arbitrage with these types of things.” Right? And so I want to get your reaction to that of, that’s a tough question. Do the folks in this asset class, especially over the last seven, eight years, are they winning because they’ve had a market tailwind around those things, and am I thinking about that the right way? Or can somebody sustain out performance over decades versus their peers in the syndications world, do you think?

J Scott:
Yeah, so a lot of different questions in there and probably a lot of different answers, but at the end of the day, it boils down to risk. There’s always going to be team risk. So there’s always going to be risk and that you pick the wrong operator or that an operator isn’t trustworthy or that an operator screws something up. So there’s always team risk, and you do your best to figure out who you’re working with and minimize that team risk as much as possible. Then separately, there’s market risk. There’s the, what happens if we have a COVID situation like we did last year, but instead of the market shooting up and assets increasing in value, what if there’s a major collapse? What if we have another 2008? And so that’s a possibility. And there are things that good operators do to mitigate those risks. In fact, they should be letting you know where the risks are and be doing what’s called sensitivity analysis to those risks.
So in certain areas, for example, I invest in Houston, and one of the big questions everybody always asks is, Houston is an oil town. And it turns out it’s not that big, only 7% of people in Houston work in the oil industry. But there’s this idea that Houston is a huge oil town. And if coal goes away, if fossil fuels go away, Houston could go down the toilet. So I need to address that risk with my investors. Is it a real risk? Is it not a risk? If it is a risk, what are we doing to mitigate it? So there’s always going to be market risk, and you want to ask the operators and you want to see, is there going to be population growth? What happens if population growth declines? Is this area basically predicated on one industry or one big employer? If so, well, what are you going to do if that employer shuts down or that industry gets crushed? And these are the questions you need to ask. These are the things that you need to look for, because there is that both location and broader market risk.
And then finally, there’s the deal risk. And the deal risk is basically, what happens if I buy that $16 million property and there’s $4 million in renovations and I get in there and I realize there’s actually $6 million in renovation. What happens if I get in there and I realize, “Oh, there’s a reason why this landlord wasn’t managing the property very efficiently.” Maybe there’s some big issue with that area where they can’t manage it efficiently. And oh boy, that’s a mistake. So there’s the risk in the deal as well. And so our job, I say that investors are purely passive, they have no control, but that’s not really the case. They have a lot of control. It’s just that their control ends the minute they hand over the money. And so a good investor doesn’t think of a syndication as a purely passive opportunity. They think of it as a hell of a lot of work until the minute they hand over the money, and then it becomes a purely passive deal. And so before they hand over the money, they need to be thinking about, again, the team risk, market risk and the deal risk.

Scott:
I love it. So when I think of this, and I think the same thing is true of regular real estate investing, but there’s dozens or hundreds of hours of self-education that needs to go into understanding the mechanics of this. If you’re not comfortable, if you can’t really wrap your mind around the concept of NOI or cap rates, which you will be able to, you know it, it’s the jargon that we’re using here, you’re going to have a hard time entering this space. And once you’ve had that education, then it becomes very quick to analyze these deals. 20, 20, 30 minutes or so with those types of things. You have to spend hundreds of hours or dozens of hours vetting each deal each time with this kind of stuff, especially if you can trust the reputation of the deal sponsor at the end of the day, because then it really is all about location, the deal itself and then the specific business plan behind operating against that and some of those things. But I think that you have a binary choice, but doesn’t mean that there’s not a lot of effort that goes into what we are calling so-called passive investing with this.

J Scott:
Yeah. Everybody in this industry, whether they’re syndicators or they’re house flippers or they’re little small time landlords or they’re note investors, whatever they are, everybody’s going to do a bad deal from time to time. Everybody is going to experience market risks from time to time. There are going to be hiccups in the market and that’s going to hurt people. The question is, what is the syndicator that you’re investing with? What is your level of trust that they’re going to foresee that coming, they’re going to have a mitigation strategy, or they’re going to be able to weather the storm. I mean, a lot of these deals, the nice thing about a lot of these deals… And not all of them. I mean, if you’re doing a development deal, you can get wiped out by a downturn in the market because you’re not generating any cash flow from your development.
We look back at 2008 and you look at all the developers, all the new construction developers that went out of business because they bought this land, they started building, and then when the market turned, they didn’t have any cash flow coming in. So inherently doing a development type syndication is going to have different risk profile and will probably be higher risk in general than doing this model where we talked about with the apartment complex, because with the apartment complex, even if the market drops, well, we’re still making cash flow month after month, year after year, and we’re very likely going to be able to weather that storm. Maybe instead of holding the property for four years, now we have to hold it for seven or 10 years. Maybe at the end of the day, we don’t make 16%, we only make 10% or 8%. But that model is inherently less risky than a development model, which is why if you go do a syndication around development, you’re likely you’re going to see much higher return promises, or not promises, but much higher return projections than you’ll see for these typical multifamily syndication deals.
So again, syndication provides a lot of opportunity for diversification. If you want higher risk with potentially higher reward, you can do things that are going to have higher market risks or higher property risks. You never want to take higher team risk. If you’re all about you want lower risk, well, there are plenty of properties out there that aren’t going to be as impacted by property surprises, maybe find a stabilized cashflow syndication. Or aren’t going to be impacted by a market dropping, find something that’s generating cashflow every month. Likewise, you can diversify across locations. So if you think San Francisco and New York is going to get crushed during the next COVID type thing, well, find a syndication that invests in some area that you think is less susceptible. Or maybe also invest in San Francisco and New York, because maybe something happens that hits smaller markets differently. Maybe diversify across different time periods, so find syndications that are two year timeframes versus syndications that are five-year timeframes versus 10 year timeframes. Or diversify across different business models, find the transactional syndications where you’re buying, renovating and reselling; and also invest in some that are stabilized properties, long-term cashflow, refinance; then find some that are new construction or development. I mean, there’s so many different ways to diversify so that you can minimize your market and your property risk.

Scott:
J, I want to point out one problem with diversification inside of syndication investing, which is usually that there are minimums to invest. So can you walk us through kind of what is a typical minimum in this world that you come across and what should I… What is the minimum and why do they have minimums?

J Scott:
Yeah, absolutely. And so I often get asked, so what are the drawbacks? Syndication sounds great, what are the drawbacks? Well, there are some drawbacks. I mentioned the big one earlier on, which is just control. You don’t have any control once you’ve turned over your money, you’re just along for the ride. Number two, you need to be accredited generally to get into a lot of syndications. Not all, but a lot of them. And then number three was just what you said, is that there’s a high barrier to entry for a lot of these deals in terms of how much you need to invest. I don’t want to speak for every syndicator, but in the industry, good rule of thumb is a hundred thousand dollars is kind of the minimum target that most syndicators throw around. A lot of them will say a hundred thousand, but if you’re a first time investor, or if you’re looking to get into that with that syndicator for the first time, a lot of times they’ll drop that down to about 50,000.
But typically 50 to a hundred thousand dollars is the minimum. If you can go higher, if you can invest 200 or 500,000, you might get some preferential treatment, higher returns or higher up in the capital stack so you get paid before everybody else, but typically we’re looking at 50 to $100,000. And depending on what your net worth is, depending on how much you’d like to put in any particular investments, that 50 or a hundred thousand dollars for a lot of us is a pretty large investment. So it is very difficult to diversify the way we can diversify with stocks or index funds or other smaller investments.

Scott:
Yeah, I think that’s, again, what makes this so interesting to me and so unique, is that because a huge amount of US real estate is owned by these syndications, it’s a big percentage of both multi-family and commercial real estate, and a lot of it is put together by syndicators, like the folks you mentioned and yourself with this. And it’s a really inefficient market because it’s generally people that have worked together multiple times on a lot of these deals and you can’t just dabble, at least not if you’re getting started, unless you have, for some reason, hundreds of thousands of dollars to allocate across five to 10 deals, you’re going to be getting into this gradually with a reasonable chunk of your liquidity, piece by piece by piece, if you’re anything like me at least, in this.
And so I think that that’s why the stakes are almost higher as a beginning, by a lot. And that’s when you’re the least educated and least comfortable with the model with all this kind of stuff, which is why I think this is just such a great discussion for a lot of folks. We know a lot of our users or listeners are just becoming millionaires and are probably interested in this asset class. And I think that those are the big drawbacks with it. The advantage of course, being I can get a 13, 14, 15, 16% return, maybe even on average, across multiple syndications. And it’s completely passive, unlike my duplex, where I might even expect a little bit more, but I have to do a ton of work. J, what’s the difference between a syndication and a fund in the sense that I see a syndicator, they just closed their latest round or whatever with this?

J Scott:
Yep. So oftentimes we hear syndication, another term we hear for syndication is a private placement or a private offering. And then we hear terms like fund or private equity or private equity fund. And so the difference between a syndication and a fund is simply that a syndication is an investment in a very specific asset. One particular deal. Sometimes we call these SPVs or special purpose vehicles. These are, we raised money to buy one particular thing, and before you put the money in, the person’s syndicating is going to say, “This is what we’re buying. We’re buying 123 Main Street, which is 412 units. This is our business plan for this building. This is where it’s located. You can go visit if you want to, this is how long we plan to hold it, et cetera, et cetera, et cetera.”
When you invest in a fund, what the syndicator or the fund operator is doing is they’re saying, “I’m going to raise X number of dollars, and then I’m going to take that money and I’m going to invest it in what I want to invest in. The things I think are good. I can’t tell you what that is today, because I may not have identified what it is I’m going to invest in.” I may tell my investors, “Yeah, I’m only going to invest in multi-family or I’m only going to invest in self storage, or I’m only going to invest in Cleveland, Ohio,” whatever it is, you can set parameters. But at the end of the day, the fund operator is going to decide where that money goes, what percentage of that money goes to each deal, and you have no say into where the money goes and you can’t make a decision if you want to invest based on specifically what it’s going to be invested in.
Now, benefits and drawbacks. Benefit of the syndication obviously is I get to see exactly what I’m investing in and I can make the decision, “Do I want to invest in this particular 123 Main Street,” before I hand over my money. With a fund, I can’t do that. I basically put my money in, and I hope that the fund operator is doing the right thing. But on the other side, with the syndication, like we were talking about, there’s no diversification. I might have to put $50,000 in-

J Scott:
There’s no diversification. I might have to put $50,000 in, $100,000 in. I’m buying 123 Main Street. If 123 Main Street goes south, I may lose some or all of my money, whereas if I put money into a fund, I can put the same 50 or $100,000 into a fund. Depending on the size of the fund, the fund operator might take that money and split it across two or five or 50 different properties. So now, I have diversification within the fund for the same amount of money. So with a syndication, you have more control over what you’re buying, but less diversification. With a fund, you have less control over specifically what’s being bought, but typically your money’s being diversified across assets or maybe locations or maybe different other types of things.

Mindy:
Okay. Let’s throw another term at you. What is the difference between syndication and REIT or real estate investment trust?

J Scott:
Yeah. So a REIT typically is a publicly traded entity. So typically with syndication or a private equity fund, syndication, also called private offering a lot of times, we have the word private in there, which means there is no public markets for you to trade your shares. If I buy into a syndication, I now own part of that syndication. I may be able to transfer those shares. If I die, I can leave them to somebody as part of my will. Legally, I don’t know if I can sell them to somebody else. Actually, I don’t know if I can just sell them to somebody else or not. But with a REIT, these are publicly traded entities. So if I buy a portion of a REIT, which is just a publicly traded fund, so it’s not a syndication, it’s a fund. They invest in a whole lot of different things. And I buy that, I can then go trade those shares. I can sell them on the open market. So that’s really the big difference between a REIT and either syndication or private equity, private versus public.

Mindy:
Okay. I want to know about something that I have not heard mentioned very frequently with regards to syndications. Let’s take Scott’s fake deal, where he purchased it for 16 million. He paid a $1 million closing costs and has… or I’m sorry, 15 million, 1 million closing costs, 4 million for the upgrades. Let’s say he goes in there. He starts tearing things apart and discovers that his 4 million is really going to be more like 8 million, but he only has $20 million. So is this the same thing as a cap call or recapitalization? I’m certainly not nearly as well-versed as you are in this, but I like to think I know something about syndications. But that has never happened to me, although I do currently have two syndications. One, if I come out of there with what I put into it, I will be lucky. And the other one, I think I made $23 last quarter. So that I think is a real possibility that people don’t talk about.

J Scott:
Absolutely. And I’m glad you brought that up because I think that’s one of those things that’s not talked about enough. I’m a big fan of transparency. There are risks when you do syndications, just like there’s risks with everything else. And I think hiding those risks doesn’t do anybody any good. I’ve seen too many people that have gotten into deals and they’ve never heard the term capital call. And then suddenly one day they’re part of one and they’re like, “Oh, I didn’t even realize this was a risk.” So let’s talk about that. So great example that you gave, you’re expecting 4 million in renovations. So you raise enough money. So you have 4 million in renovations. And suddenly now it’s 6 million in renovations needed because you found some big foundation problem or whatever.
And so where does that extra money come from? There are a couple of places. One, sometimes the syndicators can borrow more money. Oftentimes not, because generally, they’ve maxed out what they can borrow when they’ve bought the deal. You always want to borrow as much as possible because borrowed money is a lot cheaper than bringing in investors. So they probably can’t borrow more money. In some cases, the investors can put in more money themselves. So they can take their own personal cash and put it in a deal. A lot of times, the contracts call for the syndicators to be allowed to loan money to the syndication for short term. So maybe they put the money in and then take it back out. And this is all going to be laid out in the contracts that you signed as part of the syndication deal. Sometimes the operators can bring in additional investors. And so the people that are in the deal, they don’t have to come up with more money, but the operators have the right to bring in additional investors.
Unfortunately, when additional investors are brought in, they need to be compensated. So a lot of times it’ll be written into the contract that if we bring in outside investors, additional investors because we need more money, they’re going to get some of the equity. Whose equity they’re going to get? Well, they’re probably going to get some of the other investors’ equity. So the other investors may be diluted. Maybe the operators will be diluted as well.
And then there’s this thing called a capital call that you mentioned, which is a provision that’s written into most contracts, which says if there is more money that you need to come up with because there was a surprise or for whatever reason, that the investors themselves may need to come up with that money and provide more money to the partnership. And if they can’t do that, they may face penalties. They may face severe dilution. They may lose much of their equity interest even though they’re not getting their money back. And if they do put more money in, typically they still may see some dilution or they may be putting money in just to maintain their current equity stake.
So capital call’s basically this provision in the contracts that says if we need more money, we may be able to come back to you and ask for it or demand it or require it or penalize you if you don’t put more in. And there’s a million different ways it can be written up. I can’t say exactly what happens if there’s a capital call and you do or don’t put money in because there are so many different ways to do it. But capital call is this idea that there is risk that if more money is needed, you may have to put it in or you may be penalized for not putting more in.

Scott:
The good news is that when… Let’s use our apartment complex. We just purchased it for $15 million. We’re going to put $4 million into it. It’s a certain amount of units, and you’re not going to even rebuilding the whole thing from the ground up. It’s going to have some sort of cost. So a capital call can sound really scary. But I think in practice, it’s going to be rare that it’s going to be anything like even 50% or 100% of your initial investment. So yeah, I think that in a practical sense, you should be aware that that exists. But for me, that was a big mental hurdle to get over. And I think in a practical sense, it’s really not the high stakes thing that we’re discussing here in the vast majority of situations. Would you agree, Jay?

J Scott:
I’ve invested in a lot of syndications. I’ve run a few syndications now. And what I’ve found is that capital calls are very much not standard. I’ve only seen it happen on one of my deals. That was back in 2008. I haven’t seen it on any deals recently. But I do like to call it out because it is a risk. And I probably overstated it. I probably made it sound a lot scarier than it is. But again, I feel like it’s my job being on the show and telling people what their risks are [crosstalk 01:11:22] they invest in this vehicle, to understand what the worst case is. And that’s one of the worst cases.

Mindy:
So I don’t think that you are making it sound scary at all. And if somebody is listening and saying, “Oh, whoa, I don’t want to do that,” then real estate syndications aren’t for you. There are untold numbers of ways to invest your money. And if anything that you’re hearing on this episode is like, “That makes me really freak out,” then maybe real estate syndications aren’t something that you should be investing in, or certainly not these higher-risk syndications where you’re getting a better return. Like you said, there are lower-risk syndications that are giving a lower return, but it’s also not as scary. It’s not as risky. So yeah. I’m glad that you shared that because I have never had a capital call either. And I would love to go my whole life without experiencing that.

Scott:
I want to take one step back here for a second and go back. Let’s go right back to our deal with all this kind of stuff. And let’s say I’m an investor thinking about doing this. I’m just going to monologue a couple of questions. And Jay, I’d love you to point out the ones where I should be asking more questions or diving deeper on this. I’m going to use your framework. I’m going to start with the team, the location, the deal execution plan on this. I’m adding the execution plan in there in addition to the three that you mentioned.
Okay, great. I would come in here. I know Jay has posted 17, 18,000 times. The BiggerPockets Forums has been around for 12 years, completed 150 fix-and-flip projects, done those-

J Scott:
400.

Scott:
400 fix-and-flip projects. I’m sorry. I’m two years, three years out of date with this, yada, yada. Can I lose money with Jay? Absolutely. Is he going to fit away my money? I’m pretty confident, no, because he’s throwing away a 12, 15-year reputation that he’s built from the ground up both through his actions and his statements online. Great. Okay.
So I’ve got the team. I’m feeling confident about that. I know his team to a certain degree. They seem very trustworthy, very accomplished to have similar types of accomplishments across all of those things. I can actually skip some of those questions here because I know Jay, but those are the kinds of things I’d be looking for on there. Am I working with somebody… I like a good ego. Jay, I don’t know if you come across as a big ego guy, but I think that you have something where you’d have a little bit of a problem if you lost investors’ money because of a mistake or an operational execution [inaudible 01:13:52]. I think you’d be all over that with those types of things because reputation is very important to you.

J Scott:
Absolutely.

Scott:
But I like ego in this space because that’s somebody who’s going to fight to not lose your money and walk away from the deal and those types of things, to a certain healthy extent with those types-

J Scott:
can I throw one more thing out there when it comes to teams? Because this is often overlooked as well. And I don’t mean to interrupt. But communication. So remember, once you hand over the money, you’re along for the ride. You have very little say in anything. So in one respect, you can think, “Okay, communication, doesn’t matter. Whatever’s going to happen is going to happen.” But I think we all like that feeling of, “I have some control over my deal. I want to know what’s going on.” And what I have found is some of the best syndicators are also some of the worst communicators. And so what I look for and what other people should look for is a combination of both. You want a great team, a great syndication, but you also want that communication. And if you send somebody a question, because you’re thinking about investing in their deal and they don’t get back to you for two weeks, or they don’t answer the question fully, or they answer a different question that you asked, I liken it to going out on a first date.
If the first date doesn’t go well, it’s not getting better. People are on their best behavior on the first date. And same thing with communication. When you ask somebody a question and you’re potentially going to invest with them, if the communication doesn’t start out well, it’s only going to get worse. So always make sure to ask about the communication plan. So I’d say I do this, but not just me. Most syndicators do this. You’re going to get communication when the deal closes. So you’re going to hear, “Hey, deal closed today. And property management two hours later was on site, or hopefully, two hours before was on site. We’re taking over everything.” Two weeks later, a week later, three weeks later, we’re going to get, “Okay, we’ve been here for three weeks. Here’s all the surprises. Here’s all the stuff that’s happened in the first couple of weeks.”
And then from there, you’re going to hopefully get monthly updates. You’re going to hopefully get quarterly updates and financials. You may have quarterly Zoom calls where you get updates on, “Here’s how much we’re going to be distributing quarterly. Here’s your opportunity to ask questions.” So hopefully, you’re going to hear a good communication plan from the team, and you should definitely ask about that because I don’t know about everybody else, but I’m a control freak. And if I can’t have control, I at least want to know everything that’s going on. So communication is really important to me.

Scott:
Yeah. I love that. One of my first indications, the team sent me a P&L, which is with every expense coming out of the bank account every single month, which made me feel really good about those types of things. You could literally look through at any one of the syndicators and look through the LPs.

J Scott:
You should be getting at least quarterly because ultimately, the bottom of that says how much money was made and how much is getting distributed to investors, and the investors shouldn’t have to guess if they’re getting the right amount of money. They should be able to see it.

Scott:
Yep. And not only did I get a P&L, I also got a literal line-by-line breakout of every expense and everything that hit the bank account. So that kind of stuff goes a really long way. Okay.
So I have gotten to know Jay over the years, the syndicator, or gone through a lot of background to make sure I’m really comfortable with the partner or the general partner. I have had a great first date. Thank you, Jay, for that comment there. And now I’m thinking about the location. And this is, I think, more of the art of this, and I think that we can spend a little bit less time on this, but it’s like, “Hey, am I in a region of the United States or elsewhere that I think is likely to experience growth? Do I know enough about that market? Or can I hear enough from the syndicator to feel good about that place’s location within that market? Can I ask a few other people that are maybe local investors there if they have any thoughts on whether that’s an A, a B, a C, a D, an F neighborhood and what the risks associated with that are?” Any other high level things there, Jay, that you think I should be asking?

J Scott:
Yeah, absolutely. So Brian Burke, who I’ve learned a lot from has a saying that you’re looking for three things. You’re looking for population growth, employment growth, and wage growth. Those are the three big things. I’ll throw in a number four. I like to see employment diversity. I want to see lots of different types of industries and companies so that if one industry or one company goes down the drain, a whole area is not going to be affected. But yeah, population growth, employment growth, wage growth, and employment diversity are the four big things. But also keep in mind that the type of syndication that you’re investing in makes a difference. I might look at one market, let’s say. I’ll just make something up. Salt Lake City, Utah. I might look at doing a multifamily deal much differently in Salt Lake City than I would look at doing a self-storage or a mobile home park or an office complex in Salt Lake City.
So keep in mind that location is also going to be relative to the type of deal that’s being done. So when you look at a location, don’t just look at the location. Look at it within the context of, “Oh, I’m doing a development deal there. Well, what does development look like? What does the absorption rate of units look like for that type of property? How many building starts, which is basically how many new permits are out recently? So how much competition are we going to have?” These are all things you can look at. So yeah, location’s important.
The other thing I’ll mention about location is… And I never like to get political, but the reality is there are some locations that are a lot more tenant-friendly. There are some locations that are a lot more landlord-friendly. And I would suggest anytime you’re going to invest, especially in a residential type syndication, so whether it be single-family or multi-family, you ask about the legislation regarding tenant versus landlord-friendly laws, because that can play a big part. And if somebody is investing in a very tenant-friendly location, I want to see the projections address that. I want to see that, “Okay, we’re going to have more bad debt,” which means people not paying rent because of rent moratoriums. I want to see that evictions might take longer. And so we’re going to see lower income or higher vacancy economic vacancy because evictions take longer. I want to see those things addressed. So always look at that as well.

Mindy:
Yeah. I like that you brought that up. I don’t think that’s political at all. There are states in the 50-state union that we find ourselves in that lean more towards protecting a tenant’s rights than a landlord right. And I’m not saying that we should protect against slumlords, but I’m saying that there are states where it’s very easy to get an eviction and there are states that are very hard to get an eviction. There is a very fascinating thread on BiggerPockets from Will Bernard about how it took him five years to get an eviction in a property in California, not even from a former tenant. He bought it from someone, and somebody else came in, no relation to the owners or the tenants or anything, and squatted for five years, had no lease, had no anything. And it was very difficult to get that person out. That’s something that you should know.

J Scott:
Wouldn’t have believed it if I didn’t read the [inaudible 01:21:08].

Mindy:
It was unbelievable. And it’s hundreds of comments long. Of course, it is an outlier. It is not the norm. But it is something that you need to be aware of.

Scott:
I did a crowdfunding deal in Illinois. Four years to get the money back with foreclosure. Taken two and a half or something of those years. So it’s a very real risk and it dramatically changes the risk profile in a lot of these deals, and I think that it’s a great additional point with that. That apartment complex that we’re talking about 15 million, 1 million in closing costs, 4 million in rehab, if that’s in California, that project’s going to take a dramatically different risk profile. You’re going to be dealing with rent control. That’s going to make it difficult to move tenants out of the building in certain cases or move them into different ones as you’re doing it, and it’s going to cap the amount of NOI growth that you can get in there.
Compared with Texas, where you’re going to have no trouble removing the tenants the next month and improving the place. And so it makes a dramatic difference. And I think I think it’s absolutely a huge thing. And if your syndicator is not acknowledging those differences in the timeline with these kinds of things, that’s going to impact your return.

J Scott:
Absolutely. And I would never say, “Don’t invest in California. Don’t invest in Portland. Don’t invest in New York City.” What I would say is if you’re going to make sure that the syndicator addresses that sufficiently and that that is top of mind for them and make sure that whatever the risks are are factored into the returns. Higher risk should generate higher return. And it should mean that the syndicator is being more conservative in their numbers throughout the entire underwriting process.

Mindy:
Yeah. Which is a great way to vet the syndicator because I don’t know if you know this, but there is this, I believe, misconception that overly confident people can have that, “Oh, I could be a syndicator.” I mean, how many new syndicators are there? And I’m sure some of them have done their research and know what they’re doing, but I think there’s a lot of syndicators out there who maybe haven’t done deals in challenging times, and you can be left holding the bag when they haven’t planned for things that they… You don’t know what you don’t know. So, “Oh, I didn’t even know I was supposed to account for the fact that I can’t evict people for a pandemic.” Well, since we haven’t had one in 100 years, I can excuse that. But you didn’t know that you couldn’t evict people in 30 days in New York City. You should know that.

Scott:
Let’s go to the deal specifics of this. In this part of the area, this is where I’d ask some questions that I think would have maybe helped me arrive at some of the points you brought up earlier around location specifics. But hey, how long is the rehab going to take? How much are you putting into these units? If someone presents a deal to me as a limited partner and the units look like they’re in tip-top shape, I am immediately going to be like, “How are you going to add value to this deal? How is that going to work?” So are they visibly out of shape? Do they visibly need some sort of obvious rehab? Is there a plan in place that I think to me visibly improves those types of things? The common area of these places, if it’s apartment complex, are you going to meaningfully improve that? Does that matter to any major degree?
If you’re in Portland, rehabbing the pool may not be super impactful to the rents, but it may make a huge difference if you’re in Phoenix or Las Vegas with these types of things. We heard deals on the BiggerPockets real estate podcast where folks have been like, “Oh yeah, the units aren’t separately metered at some of these older complexes,” or whatever with them. Or they have that opportunity. I mean, doing that allows you to pass all of the utilities onto the tenants. Is there a believable story behind this that I can really beat up with my skeptical hat on with this indicator across that rehab and the timelines associated with it? And how realistic are those things? So Jay, tell me what I missed there.

J Scott:
Yeah. So you hit on a lot of great stuff. I would just add onto that things like it’s important to know what class of property you’re buying and what the goal is in terms of when you sell it. So am I buying a C class property that I hope to self as an A-plus class property? If so, there’s probably some flaws in my business model because you don’t turn C class properties and A class plus properties. But maybe it’s a B-minus class property that you plan to turn into a B-plus property. If that’s the case, well, what do other B-plus properties in that area have? What type of amenities and what type of finishes?
And it’s very easy to ask the syndicator, “Okay. Well, I was just looking on apartments.com and I found another B plus class property that has granite and hardwoods and a nice pool. You say you’re going to turn that into a B-plus class property. Well, are you planning on putting in granite and hardwoods and a nice pool?” If the answer is no, then how are you planning to get to compete with the B-plus class properties? The answer is yes, okay. Well now you’ve kind of verified that their business plan makes sense. And so there’s a great way to start.
It doesn’t necessarily mean that… You made the point about if there’s no visible renovations needed. Certainly that’s true to a large extent, but sometimes there’s other ways to increase the NOI. So for example, we’re looking at some properties now where we might build additional units. There’s some land adjacent to the property that hasn’t been built. So adding units, that’s another way. Even if the existing units are in great shape, adding new units. Turning an office into another unit. If you have a 50-unit property, and you turn the office into a new unit, well, you’ve just added 2% more units. And so your NOI should go up at least 2%.
And so maybe combining units or separating units. There are all different ways to make money on these things. And so make sure you’re asking specifics around the business plan. And you want to make sure that it makes sense. You don’t want vague answers like, “Yeah, we’re going to go from a B-minus to an A-minus property.” “How are you going to do that?” “Oh, we’re just going to renovate it.” Well, that’s not a good answer. What are the renovations you’re going to do? What are some of the properties in the area that you think that once you’re done renovating, you’re going to compete with? So now I can look at those properties. I can say, “Okay. I can go to apartments.com and I can see a one-bedroom in the property we’re looking to buy is 900 a month. And the syndicator’s telling me that in five years, it’s going to be just like this other property. And that property has $1,300 a month rent. Is it realistic to go from 900 to $1,300 a month rent increase based on the renovation that’s going to be done?”
Well, tell me what the specific renovation is. Tell me what amenities are going to be added. And then maybe I can decide if 9 to $1,300 make sense. So these are the types of things that you should be asking. The other thing you should be looking at is make sure that the type of property that you’re investing in is the type of property the syndicator is accustomed to doing. So oftentimes you’ll have syndicators who…
And don’t get me wrong. There are a lot of great syndicators out there that do this very well. But if a syndicator says, “Yeah, I’m going to go from investing… I own 30 apartment complexes, and now I want to go invest in warehouse space that I’m going to rehab and sell to Amazon,” that’s great, but I’m going to vet that deal differently than I would have vetted your next apartment complex because that team may or may not have experience with that type of deal. Even though that team is fantastic. And I trust them, do I trust them with that type of deal? So always ask, “Does this deal and does the business plan is going from whatever class to whatever class, is that consistent with previous deals they’ve done?” If somebody has done all A-class deals and now they’re starting to do D-class deals, that’s a risk factor for me. So I’m going to want to ask more questions about that.
Here are a couple of other questions that are really important. Ask about returns. So we’ve already talked about obviously the return amount. So is it 10% or 12% or 15%? but more importantly, remember that just like in any other real estate deal, there are different types of business plans. So I can buy a turnkey rental and I’m going to get cashflow from day one. That’s different than building a new construction house and renting it out a year and a half later. It’s going to take me a year and a half to get cashflow. We’re doing a flip. It’s going to take me six months before I get a big pot of cash. Same with syndications. If you want to invest for cashflow, make sure you’re verified that the deal that you’re investing in is a cashflow play.
So there are plenty of deals. For example, we talked about the $16 million apartment complex that we put $4 million into. That’s the example we used. If you’re putting $4 million into a $16 million or $15 million complex, there’s probably a decent amount of renovation, which means you’re going to see a lot of vacancy for the first year or two while you turn over units, people leave, you renovate them. So there may not be a whole lot of cashflow generated in year one or two. So I need to be telling my investors. And as an investor, you need to ask, “When am I going to expect to start seeing cashflow?” Because in a lot of cases, a reasonable answer is, “We’re not going to pay cashflow until year two or year three. Maybe we’ll pay cashflow in the first quarter or the second quarter.” But this is the type of question you need to ask. And you need to make sure that the answer is aligned with your investing strategy.
Maybe you don’t care about cashflow. Maybe you don’t care about increasing your net worth in five years. Maybe all you care about is you’re a real estate professional and you’ve got all this income that you’ve generated from your flips or from your selling houses as an agent, and you just want a big tax benefit. You want depreciation. So you need to ask that syndicator, “Are you planning to do a cost segregation study in year one and give me a big depreciation benefit in year one? Because that’s why I’m investing.” And so if you care about the tax benefits, ask them about what they’re going to do to maximize tax benefits.
So know what you’re looking for. Are you looking for cashflow? Are you looking for net worth gains? Are you looking for tax benefits? In what order? And what can you expect from that particular deal with respect to those three things? Because not every deal is going to return all three things in the same proportions.

Scott:
Love it. While we’re talking about the returns of this, let’s talk quickly about preferred returns and preferred equity with that. You mentioned that previously, you might say, “Hey, the limited partners might get 8% return before the syndicator gets anything.” I’ve also heard of preferred equity, really just being a flat 8% return where you don’t really participate in the upside. It’s almost more like another form of debt with those types of things. So what are the common forms of that besides is it just preferred equity and common equity? Or do you see other types of structures or what’s common?

J Scott:
Yeah, so we talk about this thing called the capital stack. And the capital stack is really just an overview of what all the different capital coming into a deal looks like. And we talked about the two big types of capital coming into the deal. We have debt, and we have equity. Debt is when you borrow money and you pay a fixed amount of interest, and that person or that that institution has a lien against the property. They can foreclose if you don’t pay. And then there’s the equity piece where you’re a partner, you get part of the profits, part of the losses. If the deal loses money, then you lose money. And so there’s debt and there’s equity. In the capital stack, that’s how we break up the capital stack, debt and equity.
On the debt side, there’s two different pieces, although we only really talk about one piece in the syndication world, and that’s your main debt provider, and that’s generally Fannie Mae or Freddie Mac, or some big bank that’s loaning money against the property. And so typically, on a syndication deal, there’s going to be one lender, and you’re going to get as much money from that lender as you possibly can as the syndicator because again, debt is a lot cheaper than bringing in investors. So that’s the debt piece. So you’re going to have one lender for hopefully 70 or 75 or 80% of the total purchase price or the deal.
And then as you mentioned on the equity side of the capital stack, there’s two different types of equity. There’s common equity and preferred equity. Preferred equity is this this weird thing. Yes, it’s sort of like debt. It’s sort of like equity. Typically, unless you’re investing many millions of dollars, unless you have your own fund, unless you have a family office, unless you’re a hedge fund, you’re probably never going to be investing as preferred equity. Preferred equity investors are people that invest a whole lot of money, and then they get this nice return that’s sort of like debt, sort of like equity. So you can know that those people are out there.
You should ask about the capital stack on anything you’re investing in. Ask flat out, say, “What does the capital stack look like? So where are you getting the debt from and how much? Where are you getting the equity from and how much?” And so you may see something in that answer that says preferred equity. But typically, it’s just common equity, and common equity just means that the LP and the GP, the operators and the investors, are just splitting all the equity in the deal, 100% of the equity, some way, 70-30, 60-40, 80-20. And like I said, typically, the investors are getting the larger percentage of the equity. The operators are getting a smaller percentage of the equity. But at the end of the day, I mean, you can slice and dice this a million different ways, but most indications is going to be one big piece of debt, one big loan, and then the investors and the syndicators splitting all the equity in some fashion. 70-30 is pretty common.

Scott:
If you’re listening to this and you go out and look at a bunch of deals, you’re not even going to see the words that we described in a lot of these offerings. You’re going to see them as Class A shares and Class B shares, and maybe even Class C shares in these deals. They’re going to be preferred. There’s going to be common. There’s going to be hybrid, whatever, with all this kind of stuff. So I think it’s really a form of getting familiar with that kind of stuff. And perhaps [inaudible 01:35:51] I imagine many of the BP money listeners who would be interested in syndications as a rule are probably going to be looking for the simpler, common type equity where you’re just, “Hey, your proceeds are based

Scott:
… common type equity, where you’re just, hey, your proceeds are based on the timings of cashflows in the deal, which will be, in a deal like what we just discussed, years two and three will when it really begins cashflowing, and then all the money will be returned, in effect, that lion’s share will be returned when the asset is sold, and the proceeds are distributed down the capital stack, as you described.

J Scott:
Here’s something I always recommend. Just like if somebody said to me they wanted to learn how to flip houses, the first thing I would recommend they do is go look at a hundred houses before you buy anything, get familiar with what you’re doing, with what you’re potentially buying. Well, same thing in the syndication world. Don’t go out and pick an operator, a syndicator, and say, I like him. I’m going to invest in him. I’m going to invest in the first deal that he or she brings to me. Instead, start looking for these syndicators, and trust me, they’re everywhere, people that talk about private offerings, or they may say syndications, or they may say large pool deals, or whatever it is, and go sign up to get on their mailing list because they’ll send you deals that they have.
And typically when they have a deal, what they’ll do is they’ll do a Zoom call with a presentation, with a walk through a presentation. They’ll talk about, hopefully they’ll do this, they’ll talk about the team, and they’ll talk about the deal, and they’ll talk about the location, and they’ll talk about the risks, and they’ll talk about the returns and all of these things. And it’s free to sit in on those calls. They’re not even going to ask you if you’re accredited. They’re not going to ask you any questions, because they’re just happy that you’re there. They’re hoping that you’ll consider investing. If you’re not accredited, they’re still thrilled, because one day you might be and they hope you’ll come back. So go sign up for all of these investor presentations and start watching them, even if you’re not yet accredited.
And by the time you’re ready to invest, hopefully you’ve watched five or 10 or 20 of these, and you’ll start to see the similarities in the presentations. You’ll start to see the differences. You’ll start to hear these same terms over and over. A lot of times, they’ll take questions. Don’t be scared to ask dumb questions. Don’t be scared to say, “Hey, you keep talking about this preferred return thing. Tell me what that means.” Because trust me, they need you more than you need them. They’re happy to answer that question. So watch the presentations, ask the questions. Hopefully by the time you’re actually ready to invest, you’ll have a much better understanding of what’s actually going on and how the moving pieces work.

Scott:
Love that. And let’s highlight it now as the final thing here, one of the final things, the way the syndicator makes money. Let’s use our deal here. We just put in nine million in equity and 11 million in debt to purchase the asset for 15, closing it for one, and put four in there. The syndicator puts zero dollars into the investment. It’s all equity raised from limited partners. How do they make money?

J Scott:
Yeah. So first of all, and I don’t want to come down on any syndicators, but me, as an investor, there’s no reason a syndicator can’t put money in a deal. And me as an investor in other people’s deals, I will almost, I can’t think of any time I’ve ever invested in somebody else’s deal where they didn’t invest in the deal themselves. And there’s nothing wrong with asking flat out, is the GP, are the operators planning to invest anything in the deal themselves? And if so, how much? So that’s the first thing I’m going to say. Nothing wrong with operators investing in their own deals.
I actually got into syndication because I was sitting on all this cash that I was investing with other people, and I’m a control freak. And I hated investing in deals where I’d hand the money over and then have no control. So I literally started investing in syndications so that I would have a place to put my own money. So I invest in all my syndications, and I know a lot of other syndicators do the same.
Now, where do the syndicators make their money if they’re not investing in their deal, or in addition to investing in their own deals? Two places. One is the fees and the other is the profit splits. So for fees, typically, there’s this thing called an acquisition fee, which the day the property closes, the syndicator will get between one and three percent of the purchase price as a fee for finding the deal, doing due diligence, taking the risks with the earnest money. A lot of times with these deals, you need to provide earnest money that’s non-refundable on day one. So if you don’t close, you risk losing that money, and that’s the syndicator’s money, it’s not investors yet.
So they get one to three percent of the purchase price, and what’s called an acquisition fee, on day one. Typically, the larger the deal, the smaller that fee is. If it’s a $50 million deal, syndicator’s not going to take three percent of that, they might take one percent or less. And often it’s, this is worth noting, a lot of times when a syndicator says, we’re going to invest our own money in the deal, a lot of times they’re taking that acquisition fee, that one percent of the purchase price that they’re getting from doing the deal, and that’s what they’re investing in the deal. And as far as I’m concerned, that’s fine. They still have skin in the game. That’s cash they could have taken off the table, but they’re putting it back in the deal. So acquisition fee, one to three percent of the purchase price on day one.
Then typically, the person that’s managing the deal, whether it’s the same team or they may bring in a third party, what’s called the asset manager, the person whose job it is to carry out the business plan, typically, they’re going to take one percent of some number every year to compensate asset management. And when I say some number, it’s not that I don’t know what that number is, it’s that it changes. So sometimes it’s one percent of the effective gross income, so the total income that’s being brought in. Sometimes it’s one percent of the money invested in the deal. Sometimes it’s one percent of the NOI. But basically, one percent of some number every year is going towards asset management and that fee.
And remember, a lot of times the syndicators aren’t making a lot of money during the whole of the project. They make the bulk of their money at the end. So making these fees throughout, not necessarily justifying, but this is how they’re staying solvent and paying their bills until they hopefully get the big pay off at the end. Then they may get what’s called a refinance or a disposition fee, capital asset fee, of one to two percent. So when the property is refinanced or when the property is sold, there’s this big pot of money that’s coming in. So the general partners may take one to two percent of that total money that’s coming in, as a fee for dealing with the refinance or dealing with the sale. So those are the three big fees that you’re going to see, an acquisition fee, asset management fee, and then that capital fee, that refinance or disposition fee.
There can be other fees. There are lots of other fees out there. I think of them as kind of junk-

Scott:
What about carrying the deal?

J Scott:
So that goes into the profit splits. That’s the next piece. So you can see lots of other fees. And I think of most of the other ones as kind of like junk fees. It’s just a way to pad the syndicator’s pocket, but maybe they’re reasonable. And then the second piece is the carrying. So when you say carrying [inaudible 01:43:02] the promote, the carried interest?

Scott:
Yeah, I’m talking about they make money in a major way when the investors get paid and things are going according to plan.

J Scott:
And that’s the second piece. So the first piece is the fees. The second piece is a split of the profits. So every year, hopefully every quarter, most quarters, investors are going to get some amount of cashflow. And again, they get a first X percentage of the cashflow before the syndicators get anything. But if there’s more cashflow than what is promised to the investors, then the remaining cashflow, anything over and above, is then split between the investors and the syndicators in some percentage, again, going back to the 70/30 or 60/40 or 80/20.
So the syndicator, if they do a good job of managing the property and are generating good cashflow every quarter, every year, they’re going to be making some money just in cashflow alongside the investors, as they’re holding the property. And then as you alluded to, there’s this big thing at the end, sometimes called their carried interest, sometimes called their promote, sometimes called their profit, but this big pot at the end when the property is sold or refinanced, let’s say for the $30 million, and there’s, let’s say $10 million in profits at the end of the day, investors have gotten their eight percent preferred return on their cashflow.
And let’s say there’s $10 million left. Then whatever that split of the equity was, let’s say 70/30, that will go to the investors and the syndicator. So if there’s $10 million in profit at the end of the day, the investors may get seven million of it to split, based on how much they put in. And then the syndicators, the operators, will get the other three million, and that’s where the bulk of their money is made. So the operator is taking generally a lot of risk, but potentially has a lot of reward on the back end if they can carry out their business plan as anticipated.

Scott:
Yeah. And thank you. This is, as you can tell, this is a convoluted world you have to enter into. It all makes sense at the end of the day, once you get familiar with it, or a lot of it does. You need to be able to determine what’s ticky tack and what’s reasonable in the context of this stuff, per J’s great points here. But at the end of the day, I think my biggest takeaway is the syndicator is highly incentivized to raise as much as possible to do the biggest deals possible and to explode and to move past those return thresholds, if they’re promising those floors, so that they can get a piece of the carried interest with this, or the promote, or the profit at the end of the day. That is really the 80/20 of the game that the syndicator is playing here.
And so that’s the pressure in this environment and why they’ll take your call and tell you about the deal flow and help you study that kind of stuff. Because at the end of the day, the more money that’s raised, the more money that the syndicators make in this space with it. It can still be a great asset class and all those kinds of things, but understand that that is, generally speaking, going to be the number one driver of the motivating factor for the syndicator, the general partner putting together the deal. Would you agree with that, J?

J Scott:
Absolutely. And since a lot of the listeners I know are not just real estate folks and don’t just invest in real estate, keep in mind that this whole model is not just a convoluted real estate thing that real estate investors made up. This model is typical with hedge funds. This model is typical with venture capital and angel investing. This model is basically anywhere that you see a bunch of pooled investor capital allocated to buy assets. This is the model.
There’s going to be those fees. There’s going to be the split between the investors and the operators. And then there’s going to be some level of return promise to the investors. And then, if the operators do a great job of making a ton of money, they’re going to make a lot of money on the backend. So this is, again, not just real estate. This is pretty typical across a lot of industries and asset classes.

Scott:
Awesome. Mindy, do you have any other questions before I get into that? I’m sorry. I was just going.

Mindy:
Well, the thing about syndications is I have 5,000 questions, but I think this is a really great high-level view of the things you need to know about. There’s a lot of people throwing this around about how they are going to be syndicators, or they’re going to invest in syndications. And I’m like, ooh, you could make a lot of money, but you could also lose a buttload of money. And I mean, you know who I’m talking about, J, when I say there’s a bunch of people out there calling themselves syndicators.
J, you have alluded to several questions that you should ask, that one should ask their syndicator before jumping into a syndication deal or before investing with them. Let’s go over some of the big ones. I am an accredited investor, and I want to invest in syndications, this new thing that I heard of. What is the first question I should ask? Or what are the top questions?

J Scott:
Yeah, there are a lot of questions, and we actually hit on a bunch of them throughout this discussion, but it’s worth recapping because these are the things you’re going to want to know to make your decision whether to invest or not invest. First is all the questions about the team that we discussed. So track record and reputation and all that stuff. Second, all of the things we discussed around location. So what is the risks of the location, and what are the population and employment and wage growth in the location? All that.
Third is all the questions around the deal specifically. What do the returns look like? Always ask specifically, what are the big risks in these deals? Because legally, that needs to be disclosed, as per SEC regulation, but you don’t want it to be in the fine print. The syndicator should be happy to tell you exactly what the risks are, because if it happens, they don’t want to have to come to you and say, “Oh, I hate to tell you, but I didn’t mention this before, but here’s a risk.” Get those out upfront so that if it happens, the syndicator can just say, “Hey, we knew this could happen. This is what we’re going to do about it.”
Then once you get through the team, the location, the deal, those big things, ask questions like, do you have an investor presentation? Are you going to do a Zoom call where you’re going to walk me through the team, the location, the deal, and allow me and other people to ask questions? So do you have a presentation that you can either send me or walk me through?
Number two, what’s the minimum investment? Remember, I said a lot of times the answer is going to be $100,000, but if you can’t invest $100,000, don’t be shy to say, well, will you do 50,000? Will you do 25,000? Worst they can say is no, there’s no legal requirement for them to insist on $100,000. Typically, syndicators like larger amounts, because if they can do larger amounts, there are fewer investors, and fewer investors means less overhead and fewer tax returns they need to generate, and easier communication and all that. But there’s no reason why a syndicator can’t say, “I’ll let you do 5,000, even though everybody else is doing 100,000,” if they want to. So ask about minimum investments.
We talked about capital calls. Definitely ask about capital calls. So what’s going to be in the legalese in the contract? You’ll see it before you sign, but it’s worth having this discussion upfront. How do you deal with capital calls? It’s worth asking, have you ever required a capital call in the past? How did that work out for your investors, for the deal? Did the deal end up being successful?
Ask about accreditation requirements. Again, most syndications require accreditation, but it is legally possible for a syndicator to do a deal that doesn’t require accreditation. They can bring in a certain number of investors that, they have to know these people, they can’t just be strangers. In theory, they have to be friends and family and that sort of thing, but you can build a relationship with a syndicator over time, and a lot of syndicators will do deals where they will bring in sometimes not accredited investors. So if you’re not accredited, don’t think that you can’t find a syndication deal. It is going to be harder, but they’re out there.
If you’re going to invest a lot of money, so let’s say minimum is 100,000, but you’re thinking, I might invest 500,000 or 600,000, well, don’t hesitate to ask the syndicator if you can get better terms for a larger investment, because remember, fewer investors makes this whole thing a whole lot easier for the syndicator. They have to deal with fewer people. They have to raise less money. They have to do fewer presentations. So if you’re bringing a lot of money, don’t hesitate to ask if you can get compensated for the extra money.
Ask about how frequent the distributions are. So are you going to be doing monthly distributions or quarterly distributions or annual distributions? Ask about when the distributions are likely to start. So, again, a lot of times for these investments, we assume as investors, I’m going to get, if they’re doing quarterly distributions, we assume we’re going to get that starting the quarter after we invest.
But a lot of times, if there’s a bunch of renovation that needs to be done, there may not be a lot of cashflow for the first several quarters. So it could be six months. It could be 12 months. It could even be 24 months before the syndicator is planning to make a distribution. It’s not a big deal, as long as you know about it and as long as you’re okay with it. That’s not uncommon, but you don’t want to find that out later, when you’re expecting money and you don’t get it.
Ask the syndicator if they’re going to be doing a cost segregation study, which is basically a way of providing a lot of tax benefits in your one, especially if you’re a real estate professional. Talk to a good accountant, because there’s a lot of benefit to getting these big tax benefits, especially if you’re a real estate professional.

Scott:
Yeah, let’s just spend one second on that, because that’s a big one. In many of these deals, you’re going to lose a lot of money on your K1 on those types of things. And so that makes the syndications I think particularly appealing to real estate agents, property managers, full-time investors, those types of things. But if you work a full-time job, you’re a doctor or a lawyer or whatever, you’re not going to be able to declare those as losses. I think that they’ll just pile up against the eventual proceeds of the deal. So you’re still accruing a tax advantage. You’re just not being able to offset your advance, your income that year. Is that right?

J Scott:
Yep, absolutely. And so yeah, you may find that those tax advantages can offset the income that this particular syndication or maybe other syndications are providing you, but you’re not going to be able to use it to offset your non-syndication income. Also worth mentioning, and this goes back to you always should be making your investors aware of everything, the good and the bad, this is on the bad side. Depreciation is this really cool tax benefit that you can use to save a whole lot of money potentially on your taxes every year. But when the property is sold, you need to do what’s called depreciation recapture, which means any tax advantage you got during the whole period of that deal, you need to now repay to the government when that deal is sold.
Now you might say, well, if I have to repay it, how’s it an advantage? Well, it’s an advantage because money today is more valuable than money tomorrow. So saving money on taxes today is worth paying that same amount back a couple years from now. But one of the big ways to avoid paying a big tax bill in three or five or 10 years, when the property is sold, is to expect that you’re going to take any money that you make from a syndication and roll it into another syndication. Because if you do that in the same year, typically you’ll see a big year one tax benefit that will offset that tax hit that you took when the property sold. So that’s just something that isn’t talked a lot about in the syndication world, but it’s called rolling your investments.
And what you’re going to find is if you roll your investments for five or 10 or 30 years, you’re not going to see any big tax hits, but one day you may stop investing in syndications and you’re going to find that all those depreciation recapture is all going to hit you at once, and you’re going to have a big tax bill at the end. So just something to keep in mind. Talk to your accountant or CPA if you’re concerned about it.
What else? Ask about the fees that the sponsors are getting, that the syndicators are getting. Because again, they shouldn’t be shy about talking you their fees. They shouldn’t be embarrassed by their fees. Hopefully they’re earning those fees. And if they ever try to hide fees, like if you see something written in the legalese, in the documents, that they didn’t disclose, call them on it, because fees are a big part of how syndicators get paid, and it’s a big part of how they align their interests or don’t align their interests with their investors. And so they should be disclosing that from day one.
Talk about what that preferred return is, that guaranteed amount that comes back to the investor before the operators get anything. Normally, that’ll be in there. Talk about what the percentage split is, because again, it’ll be in the legalese, but you also want to know upfront. Is it a big split in favor of the investors or a big split in favor of the operators, or what?
Ask about the communication plan. We talked about that. So are you going to have monthly updates, quarterly updates? Am I going to see, like Scott said, am I going to see the actual financials? Am I going to see the P&L? A lot of syndicators will actually send the P&L for the property, which is good. I want to see the exact data, and I want to see it quarterly.
And then don’t be scared to ask about references. Can I talk to other investors who have invested with you? Can you give me the names of people on multiple deals? Don’t just give me the names of four people on the same deal. I want to talk to people from different deals, because not all deals go well. Can you tell me about a time that a deal didn’t go well? Explain to me the situation, just like when you’re hiring somebody, tell me about some time that you were at your job and things didn’t go well. As a hiring manager, you want to know that, because you want to know if this deal goes south, how is that team likely to respond? Are they going to run away and give up, or are they going to fight and get creative and figure it out?
Ask about when K1s are distributed. So at the end of every year, the syndication needs to distribute tax returns, excuse me, tax returns to the investors. A lot of them are really slow on doing that. They’ll file extensions, which means you have to file your extensions. You want to hear that they’re going to get you your K1s by like the end of February so that you can file your taxes on time.
And then the last thing I would say is depending on how you want to invest, ask if you can invest using a 1031, if you’re looking to 1031. Ask if you can invest using your IRA, and that’s a whole separate subject, but a lot of the syndications, if you want to invest with your IRA, you can. There are some potential downsides to investing with your IRA. But if that’s where your money’s coming from, make sure you ask if they support that. Yeah, those are the big questions that I would ask before considering any investment into a syndication.

Mindy:
Yeah, that seems pretty exhaustive. Oh my goodness, J, this has been a super fabulous episode. This is all the stuff that I want people to know before they just jump in with both feet, because real estate syndication is this sexy new thing and everybody’s getting into it. And I think there’s some really great syndicators out there. And I think there’s some people who might not even know all the things that you just said. And frankly, if your syndicator doesn’t know all this stuff, they should not be your syndicator. You should let somebody else try their hand with that because, you know-

J Scott:
Go with your gut. If you get a bad feeling from somebody, if you’re not getting your questions answered, if you don’t feel like you’re getting straight answers, I mean, just like anything else. And don’t hesitate to build a relationship. I mean, yeah, there are going to be some syndicators out there who might pressure you, but don’t hesitate to say, I’m going to sit in on five or 10 presentations and then maybe I’ll do a deal. And if they have a problem with that, well, they’re probably not the right group for you to be investing with. It doesn’t cost them anything.

Scott:
If they’re too good for your money.

J Scott:
Yeah, yeah. It doesn’t cost them anything to let you sit through a bunch of presentations. They should be thrilled that you might eventually invest. And so if they’re not, find somebody who is.

Mindy:
Yeah. I want to correct you, which I hate doing in this episode because you’ve been so awesome.

J Scott:
Please.

Mindy:
You said, go with your gut. I would say, go with your gut when your gut says no. Don’t go with your gut in place of doing research.

J Scott:
A hundred percent, yes.

Mindy:
But if your gut says no, that is all you need. That’s all the information you need to be like, you know what? Because it’s way better to have not invested in J Scott’s deal because you went with your gut and you didn’t, and he did these amazing returns, than to ignore your gut saying no, jump in with him, and he’s like, oh yeah, by the way, I just stole all the money and you know, sorry.

Scott:
Yeah, I’ve talked about all this kind of stuff. Can you tell us a little bit about what you’re doing? We won’t do the famous four today. We’re just going to ask you to share a little bit about what your business is, and you’re putting together syndications, right? Can you tell us a little about those?

J Scott:
Yeah, absolutely. And I mentioned it earlier, so a couple of years ago I was getting a little bit burned out from doing the flipping thing and the residential, the single family residential stuff. And so I took a little bit of a break, but I still wanted my cash to be working for me. So I started investing in a bunch of syndications. And what I found is that I really enjoyed investing in them. I was getting good returns from them, but I hated the fact that I had absolutely no control whatsoever.
So I said, well, how can I leverage my knowledge and real estate and be able to still get these returns, but also feel like I had some control. So I decided to do the syndication thing myself. I partnered up with a woman named Ashley Wilson, who has done a whole lot of multi-family stuff for BiggerPockets. If you’re not familiar, go out and look up the BiggerPockets YouTube channel, and a lot of the stuff that she’s done in multi-family. But she took me under her wing a couple years ago and she offered to teach me the multi-family space because she’s done it for a long time, has a lot of units.
And over the last couple years, she’s kind of taught me everything I know, not necessarily everything she knows. And a few months back, we decided to form a formal partnership. We make a great team. She’s really good on the acquisition side and on the asset management side. I’m good on the underwriting and the fundraising side. So we kind of split up, divvied up responsibilities, built a team, and now we’re focused on doing multi-family syndications across Texas and the Midwest.

Scott:
Awesome. What is the name of your group?

J Scott:
Yeah, so our company is Bar Down Investments, B-A-R Down Investments. You can find out about us at bardowninvestments.com.

Scott:
All right. We’ll link to all of that in the show notes here. And Mindy, we should put our heads together and think about whether we can put together a list of these questions that J called out here as a downloadable, as well, for folks. Again, those will all be at biggerpockets.com/moneyshow. What number is this?

Mindy:
219.

Scott:
219.

Mindy:
219.

Scott:
Biggerpockets.com/moneyshow219.

Mindy:
Okay.

J Scott:
I can provide something.

Mindy:
Awesome. Awesome. Okay. Thank you, J. And wow, this was just an enormous amount of information and I can’t think of somebody better to ask all of these questions of and have all this information from. So thank you so much for taking time out of your day to share this with us. This is going to be hugely helpful, and I’m sure our listeners are going to be like, how do I get in touch with J? I have nine million more questions. Well, Bar Down Investments. Wait, what was it, bardowninvestments.com?

J Scott:
Yep. Or you can go to connectwithjscott.com or investwithj.com.

Mindy:
Ah, there you go. Okay. Awesome. J, thank you, thank you, thank you. You are the bomb diggity.

J Scott:
Aww, I love you guys. Thank you for having me.

Mindy:
Okay, we’ll talk to you soon. Holy cow, Scott, that was an enormous amount of information very logically laid out, very clearly laid out, by our delightful J Scott. You know, I love near the end where J suggests finding multiple syndicators, getting on their mailing list, attending their Zoom presentations, and asking questions. I think that that’s probably the best piece of advice from this whole amazing episode of more than two hours of massive fabulous information.
Ask questions. If the syndicator isn’t forthcoming and welcoming and willing to help you learn, maybe that’s just not the syndicator for you. And that’s a great way to start checking people off the list, because there are a lot of syndicators out there. And if you are interested in investing in real estate syndications, you need to find somebody who aligns with what you’re looking for.

Scott:
Yeah. Now I have a question for the listeners. You’ve made it through two hours and 15 minutes now, or however long this show has been. You’re still with us, here at the very end. I am really interested in gauging what the interest level in the BiggerPockets community is in learning how to passively invest in syndications.
So if you are interested, please send me a personal email, [email protected], a little bit about your backstory and interest and what BiggerPpockets might be able to do that would be most helpful to you. So I’m really interested in collecting that feedback and learning about this. I’m really interested in syndications, but I’m not sure how many other people out there are also interested and would love to learn more about what the problems are, and if this was helpful, what we could do to make it more accessible, this world of syndication investing.

Mindy:
Oh, that’s awesome, Scott. Yes, [email protected] or give him a … I’m just kidding. I was going to say, give him a phone call at 1-800-

Scott:
Absolutely. I probably will hop on the phone with a couple of folks. So yeah.

Mindy:
Okay. Well, we really hope you enjoyed this episode as much as we enjoyed making this episode, because talking to J Scott is always a dream. Scott, this has gone on for a very long time and we should let our listeners get on with their day. Are you ready?

Scott:
Let’s do it.

Mindy:
From episode 219 of the BiggerPockets Money Podcast, he is Scott Trench and I am Mindy Jensen, saying stay out of trouble.