Passive Investing: Syndication vs Private Lending

Passive investing is a great real estate strategy because it requires little, if any, involvement in hands on management of assets. Two forms of passive investing are syndication and private lending. These strategies are great for current real estate investors looking to expand their portfolio, a person who does not want to be a landlord, a professional in their career like a doctor, lawyer, CEO, who has a great income or a surplus of cash, someone with a sizable retirement savings account, a retiree looking for a passive income, a tech entrepreneur who owns a successful startup or a lottery winner. Keep reading and see which strategy may be right for you.

Syndication
Syndication at its basic form is the pooling of investor money where the investor is a passive (silent) partner called a limited partner (LP). The other partner is a general partner (GP) which is the decision maker or decision making team. The GP puts the deal together and implements the business plan to provide a return for the benefit of all investors. GP’s can also be called, syndicate, sponsor, or key principal. Limited partners’ risk is limited to the amount they invest in the deal, nor can they be sued, are not on the loan and are not responsible for performance or management of the property. 

The pros of the syndication model are that it is completely passive (no trash tenants or toilets -yay!), has limited liability for investors, has pass-through tax benefits, gives investors equity ownership, utilizes leverage of several partners to have a stake in an asset they wouldn't be able to purchase otherwise, has consistent returns, is self directed IRA approved, and has professional, proven asset management. The cons of syndication are lack of decision-making power, limited liquidity as many assets are held on average 5 years, less upside potential, and an investor may need to be accredited to participate in an offering. An accredited investor is a person who must have an annual income exceeding $200,000 ($300,000 for joint income) for the last two years with the expectation of earning the same or a higher income in the current year. A person is also considered accredited if they have a net worth exceeding $1 million, either individually or jointly with their spouse.

There are several ways that syndications benefit investors: 1. Investors receive cash flow from the rental units in the form of distributions from the general partnership, 2. Many times, syndicators will perform a refinance after a few years of operation due to increased value because of better management and upgrades, which allows investors to receive part or all of their capital back, without a change in their share of equity of cash flow and profit distributions, 3. Profit from the sale which can happen anywhere between 3 to 10 years, depending on the deal structure and business plan.

Depending on how the syndication is registered, it may be available to members of the public who are accredited investors or it from word of mouth from a friend, family member or business associate who is a passive investor in a syndication and can refer you to a syndicator or is a syndicator themselves. If a person doesn't have any connection to syndicators or friends investing in syndications, they can easily join some social media groups to learn who different syndicators are and how to become involved in their offerings. 

So how does a passive investor get involved in a syndication deal? Once a sponsor or general partner puts a property under contract, they will begin their due diligence to ensure the property will perform well for all investors involved. After the initial due diligence, potential investors will be invited to review the deal with the general partnership which will cover the business plan, the projected income and expenses, projected returns and have the ability to ask any questions they have about the deal. Many syndicators use online portals to allow investors an easy way to read documents and transfer funds to participate in the offering. Once an investor knows they want to move forward, they will tell the general partners, many times through the investor portal, the amount they would like to invest, known as a soft commitment. After a soft commitment is given, the investors will receive an electronic copy of the disclosure about the investment called a Private Placement Memorandum (PPM), that they will have to read and sign electronically. Most syndicators prefer to have funds transferred at least 3 weeks before the closing date. Once the property closes, the general partnership will begin implementing the business plan and provide returns, which can be monthly, quarterly, semi-annually or annually, and upon refinance and/or sale of the asset.

Becoming a LP is a great way to get into real estate and one of the least risky ways to do so.

To give an idea of the returns an investor may see, let's assume they invested $100,000 which garners them ~3% equity in a $3.5 million asset with an average return of 8% over 7 years. By the end of year seven, investors will have received their original capital investment of $100,000 back, along with approximately $56,000 in cash flow distributions, and $75,000 in proceeds from the sale if the property value increased to $6 million for a total of $131,000 in earnings. In this example, the investor would have more than doubled their original capital investment over the 7 year period. 

Private Lending
What is a Private Money Lender (PML)? A PML is an individual (non-bank) that loans money, generally secured by a note and deed of trust, for the purpose of funding a real estate transaction. They can be a private citizen or group of them who offer money based on their own terms. Those terms are worked out explicity between the PML and the borrower. Private money lenders are generally considered relationship-based which means they lend to people they know, like and trust first, and lend on the deal underwriting and potential second. PML’s usually fall into one of two camps: 1. an investor who simply doesn’t want the hassle of owning properties and dealing with tenants or 2. an investor who has already acquired a healthy number of properties and simply wants to diversify. Private money lenders can also be any of the people mentioned in syndication, however there is more work in terms of bookkeeping, ensuring funds are deployed and not sitting idle in a bank account, some due diligence on borrowers and assets and working with legal counsel to ensure all protections are in place like recorded notes and deeds.

Private money lenders generally lend to two types of real estate strategies: flips or buy and hold (rentals). In terms of risk, flips tend to have a bit more risk due to the fast nature of the work and real estate market at the time of completion. The longer a flip takes, the less profit an investor makes, and if a flip takes too long, it can create a break even, or negative profit situation that may affect the PML and their investment. Buy and Holds have a bit more flexibility because they are a long term asset and aren't based on the sale of the property to return investment capital to an investor. Buy and holds generate consistent income, and an operator can increase the value by completing upgrades to the standard of other updated rentals in the vicinity of the subject property. Once an operator has increased rents and value, they can refinance the property to a traditional mortgage, and return the investment capital to the PML. Both strategies prefer to provide cash offers for properties, which is why so investors many seek to befriend private lenders.

The benefits of becoming a PML are that PML's are secured in 1st lien position, they can seize the collateralized asset through foreclosure, or potentially have the borrower waive their rights to foreclosure, meaning the PML does not have to go through a months long process to dispose of the asset to receive their capital back, and the investment is relatively liquid (6-18 month typical loan timeframe). The cons of private money lending is that it offers no asset appreciation, no tax advantages, long term lending can be at risk of inflationary loss, a PML should have basic renovation and market knowledge needed to analyze potential deals from borrowers, private lending is not truly passive and small asset classes can be risky.

A private money lender makes their money several different ways. The first way is the interest payments they receive from the borrower. Many PML's allow interest-only payments which gives borrowers more flexibility by having a lower monthly payment, rather than paying down principal, so the loan balance will stay the same throughout the life of the loan. Another way PML's can make money is by requesting points on top of the loan to cover closing costs such as document preparation, wire transfers and account fees. Some PML's charge points, others don't. Traditionally, the borrower pays for the attorney fees for themselves and the PML, however, the PML retains the right to their choice of attorney. The faster the capital comes back to a PML, the more money they can make. Each time a PML originates a new loan they can make points, the more loans a person does in shorter time periods, the more money one can potentially make.

In order to protect oneself as a PML, always work with an attorney who can give guidance on the best legal documents that will provide protection to you as a lender. Documents such as a note, deed, personal guarantee, deed in lieu of foreclosure and being named on the hazard policy of the property are layers in protecting your hard earned capital. Also consider asking for a background check, or permission to do one, on people you are considering lending to. The PML is in the driver's seat. Borrowers not willing to meet the basic due diligence terms of what a PML requires may not be a best suited borrower for that specific PML, or can indicate red flags, such as not allowing a background check.

A great way for a person to find investors to lend to is by joining and becoming active in local real estate investor associations as well as local real estate social media groups. Not only will this expand the network of potential borrowers, it may also expand one's knowledge regarding real estate which can help with the due diligence process when considering lending on a deal. 

As you can see there are great ways to make money in real estate in a passive (or almost passive) manner. Choose the one that aligns with your goals, educate yourself more on the specific strategy, and you will be making a nice return on your money in no time.  As always, if you want to learn more about these, or any other real estate investing strategies, don't hesitate to reach out!