Evaluating Return as a Limited Partner in a Syndication with a long-term hold?

Question

I'm looking for advice on how to properly measure/understand the return on investment as a Limited Partner in a syndication deal with an indefinite holding period.

I'm considering investing in a Syndication with an indefinite holding period. The sponsor is trying to build a big portfolio of buildings that will provide cash flow to investors, and selling is not part of the strategy. As the Limited Partner (LP) and if the project goes well, I'll get 50% of my capital back in Year 3 and 100% of my capital back in Year 10. Any profit distributions are at a 70/30 promote. In addition, I'll get a 6% preferred return on the capital I have in the deal at the moment the calculation is made. Once all my capital is returned, my equity is reduced by 30% as part of the promote given to the sponsor. Should I view this as a sort of loan whereby I get compensated with a 6% return AND equity? And the risk of getting my loan repaid is the financial health of the building; versus say if I loaned my friend $50k with 6% interest, the risk would be the person? Furthermore, since my basis is zero once all my capital is returned, how do I calculate a return on my equity in the building once that happens? For example, if my equity is $100,000 and I'm only getting $2,000 per year in cash distributions, wouldn't it be better if I could somehow take that $10k out of building? Or is that cash all gravy, so to speak, because my basis is zero. Syndication returns are a lot clearer to me if the building is sold in 5 years, but in the case where it's held, it's confusing to me how to properly measure success.

If the building is held for 30 years, for example, is it fair to ask whether it would've been better to just put that $50k in the SP500?

Shafi Noss · Answer

This may actually be the right time to use IRR, or MIRR. Or instead of thinking about return on equity ask yourself if the schedule of cash inflows and outflows is preferable to what you could get by investing elsewhere.

For example, if you put in $100k, then after 5 years got back $100k, then got $1 per year forever, your 'return on equity' would be infinity. But it's not a good deal. IRR or series of cashflows capture that intuition much better.

When comparing, remember to adjust for risk/effort/liquidity. The S&P can be sold whenever you need cash, a syndication can't. How much is that liquidity worth to you?

Gino Barbaro · Answer

@Brian Freedman

It is not common for a syndication to have an indefinite holding period. Syndicators get paid with fees and exits. Most investors frown upon having their capital tied up into a deal long term.

I agree with long term buy and holds, but if you're working with investor capital, most investors want their money back at some point.

I would have a syndication attorney look at the PPM, and walk you through it.

Gino

Chris Seveney · Answer

@Brian Freedman

10 years is a long time to get your capital back.

Also is this a fund or syndication as a syndication is one deal vs a fund is multiple deals.

The sponsor should have a PPM and in it a proforma that shows the returns and hypothetical situations.

I always ask what happens when stuff goes wrong as it’s easy to put numbers on a sheet but how aggressive and understanding the risk is more important sometimes than the returns

Justin Moy · Answer

It's not too common for long term strategies in syndications, but if it's a heavy cash flow deal and that's what you're looking for no problem. We have 1 of those and our investors love it.

I'd use IRR to determine if this is a 'good deal', IRR will measure the time value of money and not just how fast it's returned. A deal like this is a great way syndicators can mask poor deals with metrics like equity multiples (I'm sure over the course of 30 years your equity will multiple a few times, but compared to a 5 year deal where the equity multiple is slightly less than 2, the long deal will be significantly worse in terms of time value of money because that multiple takes significantly longer for you to get back).

Think of the velocity of money, if it takes you 10 years to get your investment back, could you have invested that money in any other deals within that 10 year period that would have a greater return?

As far as measuring return after all cash is returned, I'd say that return is infinite since you have nothing to measure it against, which is a fantastic thing.

Overall, if you're playing offense with your money and looking to make as much as possible it doesn't sound like the deal will be a great investment, if you're looking to sit back and collect mailbox money and don't need to make a ton but want something secure and predictable, then it might be a good strategy.

Brett Deas · Answer

In a typical multi-family syndication holding for long periods of time 10+ years typically don't make sense. That being said, there are other syndication options that are designed for very long term holding periods. For example,

My syndication does unique stay short term rentals, and we are a very cashflow heavy operation. Once our deals are fully operational we target 20%+ yearly payouts, and some times we can get up to 50%. Once we get to that point investors make their money back within a few years and still make a better return than the market.

That being said this structure doesn't work for everybody, but for some it is exactly what they are looking for.

Gino Barbaro · Answer

Is 1000 per year? That means you are generating around 80 per month on a 100k investment

I would sell out of that deal too. do you have alll your capital out. Is your basis zero in the deal?

If you sell your position, you will have cap gains taxes? Once again, there is no clear cut yes or no answer. If you're generating the 8%, and you don't need the money for another deal and the goal is income then you probably hold

If you're making 80 bucks a month, then you probably sell and find another deal

Ive interviewed some wealthy real estate investors and they all say the two mistakes they've made is not buying enough and selling too early.

Brian Freedman · Answer

Hey @Gino Barbaro. Would a counterargument be, though, that if you have $100k of equity in a building, if it pays you $1k in steady income, that 1% return, although steady, isn't a good return and you'd be better off selling your position (if possible) and buying a CD or a treasury bond. Of course, it depends on the interest rates and other factors.

Gino Barbaro · Answer

It depends upon your goals. If you are looking for a dividend, and steady retirement income, it is a good option.

If you want the asset to continue to appreciate while paying down the debt, another good reason to keep the money in.

If you find a great deal that is newer and can be held long term and is rather easy to manage, another reason to hold long term

Brian Freedman · Answer

Thanks @David S. and @Chris Seveney and @Gino Barbaro and @Chris Seveney  for your insight.

I'm wondering when it would ever make sense to join a syndication as Limited Partner with a buy and hold strategy? What would be the rationale? To me, it makes more sense to realize the gains in appreciation after improvements by selling in 5-7 years, with the intention of rolling that return into another property. That's the goal of most syndication deals, it seems. If you invested 100k into Deal 1, you can now invest let's say invest 150k in Deal 2 if you're total return was 50% on Deal 1. And hypothetically, if you're getting a cash-on-cash return of 10% in both Deals, now you're getting $15k instead of $10k. Eventually, I'd understand holding a property once you hit an income benchmark. Let's say your goal is $50k in passive income a year. So you when you get to Deal 10, and it's paying $50k in passive income, or maybe it's Deal 10 + Deal 11 combined, then sure, you can be less concerned about ROE. The more years you hold a property, the lower the annualized returns become given that the bulk of the appreciation happened in the first few years. If the idea is to hold a property, then the ROE has to make sense, I'd imagine, regardless of what your basis is. If I'm in Year 20, and my equity value in Deal 1 is $100k, and my income from Deal 1 is $1,500, and I couldn't get the equity out because I'm an LP in a syndicated deal, then wouldn't that be a bad place to end up in?

David S. · Answer

To answer you questions, I think the investment could be viewed as an unsecured junior loan (behind the first mortgage) and you get compensated by a preferred (not guaranteed) return of 6% plus return of your equity before the sponsor can share in any of the profits. The sponsor only gets their 30% promote after you have gotten all your capital back and the 6% preferred return. It appears the plan is to refinance the debt in years 3 and 10 so that your capital can be returned.

Yes, your return will be entirely based on how the underlying property performs. If the property does not perform and is unable to make the payments on the first mortgage, the property could be foreclosed on or sold for less than what it was acquired for and all or most of your equity would be lost. If the property performs as planned, you will have gotten al your equity back by year 10 and the sponsor's pitch is that from there you will be getting infinite returns. You and all the other LPs still own 70% of the equity and no longer have any invested capital.

I once reviewed a syndication based on a forever hold. However, when I reviewed the PPM, there was a provision that allowed the sponsor to buy out the LPs at any time after their capital had been returned and had earned something like 2 or 3% more than the preferred return. I did not like that since it meant that once the property had been de-risked, my potential return was capped. I would have had effectively loaned money to the sponsor. All of the equity could have been lost if things did not go well and yet my upside was limited due to the sponsor's buy out price. So take a close look at the PPM and Operating Agreement.

If the intent is to hold the property for 30 years, I think Warren Buffet would recommend investing into the S&P 500 instead. However, you would have to be able to handle the inherent volatility that comes from investing in stocks. And you don't get the depreciation benefits...passive losses that can be used to offset other passive income.

Evaluating Return as a Limited Partner in a Syndication with a long-term hold?

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