Real Estate Syndications — Who Are They Right For?
Among some investors, real estate syndications get a bad name. Let's talk about why and how an intelligent investor invests in syndications. The post Real Estate Syndications — Who Are They Right For? appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.
By Dr. Jim Dahle, WCI Founder
There is a spectrum of methods to invest in real estate. All of the methods on the spectrum are reasonable. What is most critical for a real estate investor is to match their desires and abilities to the proper place on the spectrum seen below.
If you're really not interested in getting your hands dirty or have little investing or even real estate ownership experience, you have no business on the left side of the spectrum. If you hate paying fees and not having total control of your investments, you won't find the right side of the spectrum very appealing. Katie, Brett (WCI's COO and a former general contractor), and I have experience all over this real estate spectrum. Personally, I prefer the far right side of the spectrum. That's why we have 5% of our money in an index fund of publicly traded REITs, 5% in private real estate debt funds, and most of the last 10% in private real estate equity funds.
I like passivity, and I like diversification. Some people wonder why we go into the private world at all. Most of that is explained by high returns and lower correlation with our stocks and bonds (our portfolio consists of 60% stocks, 20% bonds, and 20% real estate). That correlation seems particularly low to me with the debt funds. But having the depreciation passed through on the private equity side is also helpful at tax time. Brett is much more comfortable on the left side of the spectrum (building from the ground up is not intimidating to him at all), but he also has some money invested passively. Different strokes for different folks.
What Is a Real Estate Syndication?
Among some investors, syndications get a bad name. Sometimes, that ire is misdirected due to ignorance. They think all private real estate is “syndications,” and they don't like the illiquidity and opaqueness of private investments. However, a real estate syndication is generally considered a single property, such as an apartment complex, owned by perhaps 100 “limited partners (LPs)” who provide capital and a general partner (GP) who runs the show. Often, these are “value-add” projects, where the syndication puts something like 30% down, buys the complex, fixes it up by renovating all the apartments, raises rents, and then sells the property off in 3-7 years for a profit.
Between appreciation, “forced appreciation” from the “value adds,” and the leverage, returns on these syndications are often in the teens or 20s, but they can also easily be single digits or even negative. Occasionally, the limited partners are cleaned out (lose all their principal) for various reasons, but it's most often related to leverage. Perhaps the project was overleveraged (it's best to put down 33%-40%) or leveraged with adjustable rate debt or the GP was incompetent or (rarely) the GP is a scammer. Or maybe a combination of some or all of the above.
Novice real estate investors hear about these rare principal-losing events and shake their heads wondering why anyone would ever invest in a syndication at all. In today's post, I'm going to explain why and how an intelligent investor would invest in syndications.
More information here:
The 5 Characteristics of My Ideal Private Real Estate Fund
The 3 Things That Matter Most with Private Real Estate
Diversification and Portfolio Construction
Businesses go bankrupt all the time. In 2022, 116 publicly traded companies in the US went bankrupt. I owned them all via my favorite mutual fund, the Vanguard Total Stock Market Fund. If I were to beat myself up every time I owned a company that went bankrupt, I'd spend my whole life covered in bruises. However, that fund only lost 20% in 2022, and it has had annualized returns of 16% over the last five years as of October 2024. Those companies going bankrupt are not affecting my ability to reach my financial goals. That's because of diversification. One hundred out of 4,000 companies going bankrupt isn't that big a deal, especially when most of them are small companies.
The same principle applies to a portfolio of real estate. If you put your entire portfolio real estate allocation into a single property, whether you manage it or someone else does, you better watch it carefully and be darn sure that it is a great investment. The more doubts you have about your (or your manager's) ability, the more you should diversify. Diversification protects you from what you don't know and what you cannot know.
More information here:
Diversification Always Matters (My Syndicated Investment Goes to Zero)
Be Wealthy
If you really want to diversify a portfolio of syndications, you probably need to be fairly wealthy. This is simply a function of minimum investments. For various legal and practical reasons, the number of investors in a syndication is generally limited to something like 100 LPs. If you want to buy a $20 million apartment complex and put 25% down, you need $5 million. Five million dollars divided by 100 investors is $50,000. Most investment minimums for syndications with experienced GPs are $50,000-$100,000. That means if you want to diversify with five, 10, 20, or more different properties, you need $250,000-$2 million+ allocated to real estate in your portfolio. If real estate is only 1/3 of your portfolio, you might need as much as $6 million before you are wealthy enough to do this right. Even if you're OK with just five $50,000 syndications and you allocate 20% of your portfolio to real estate, you still need a portfolio of at least $1.25 million. This is not a place for those with $250,000 portfolios to play. The game is too rich for most doctors in their first few years out of residency.
Now you know why I recommend you become a “real” accredited investor before you invest in private investments. Legally speaking, an accredited investor must have either an income of $200,000+ in each of the last two years or at least $1 million in investable assets. Frankly, I think you should have both. And double both of those numbers, so $400,000+ in income and $2 million+ in investments before messing with private investments. The spirit of being an accredited investor is that you're knowledgeable enough to evaluate the investment on your own without the assistance of an advisor, attorney, or accountant and that you're rich enough that you can lose your entire investment without it affecting your financial life in any significant way. Make sure both of those are true.
In addition to the diversification issue, there is also the tax preparation issue. It just isn't worth dealing with another K-1 and possibly filing in an additional state for a mere $5,000 investment. You will spend more than your profit on tax preparation fees. But when you're wealthy enough to put $100,000 or $300,000 into each of your K-1 providing investments, the tax prep cost is much less significant to your financial life.
Use Funds
Perhaps the best workaround to the wealth problem is to use funds instead of individual properties. I'm a big fan of diversification, so this is the approach I have taken. Instead of getting part of one property for your $100,000 minimum, perhaps you get part of 15. There's a lot more diversification there. I've had a fund manager mail in the keys on a property in a fund before but still managed 9% returns on the overall fund. Diversification works.
Now, if a fund manager is totally incompetent, a scammer, or badly overleveraged, you can still lose your entire investment, so you do need to diversify between managers. But $300,000 buys you three managers and 50 properties, rather than just three properties. This is why the vast majority of WCI real estate advertisers are companies offering funds instead of just syndications. I just think funds are the choice that most white coat investors who are including private real estate in their portfolios should be making.
More information here:
You Can Dial Back Real Estate Risk
Control
If funds are available, why do some investors still choose to invest in individual syndications? It boils down to control. When you buy syndications, you only have to trust the GP to run the investment well; you don't have to trust them to choose the investments well. You can evaluate the property yourself before deciding to invest. You can fly out, walk the property, interview tenants, meet face-to-face with the management team, and do background checks on the GP. Especially if you have a lot of experience with direct real estate investing, you might find this level of control while still being a passive investor to be an attractive proposition.
However, I fear that too often syndications just get sold to investors who don't actually desire that level of control or have that level of experience. This is especially bad when the investor is not yet wealthy. Those people really should (if anything) be buying funds instead of individual syndications. In addition to dramatically more diversification, private funds still have a lower correlation with stocks than public REITs and the pass-through depreciation that private real estate investors are seeking.
Becoming More Diversified Over Time
If you aren't THAT rich yet but still desire the control available with individual syndications, there is one other decent option. I'm not its hugest fan, but I will concede it isn't bonkers for people with a very high income and savings rate. If you're saving enough money that you can buy one, two, three, or more syndications a year (i.e. saving a total of $300,000-$1 million or more a year), it won't take very long to build a diversified portfolio of syndications. Maybe it's OK if you're not very diversified for a year or three. If you're saving those kinds of amounts, you're going to be very wealthy eventually no matter where you're investing.
More information here:
A Tale of 2 Sponsors: How My Real Estate Investments Have Had Vastly Different Results
Lower Minimums
Another option for those who aren't so rich is to buy syndications with lower minimum investments. There are a fair number of “crowdfunding” sites that offer syndications with lower minimums, such as $20,000 or even $2,000. These are generally less expensive properties and sometimes just a single home. A bigger concern for me is that the GP is often not very experienced. I think you're gambling a bit more with those low minimum investment syndications. The tax preparation cost is also the same, whether you invest $5,000 or $500,000. I think it's OK to invest in a few of these (and I did) to get your feet wet and learn a bit, but I just don't think low minimum investment syndications are a great way to build a portfolio. You're not getting the best properties, the best managers, or the best value for your tax prep dollars.
The Bottom Line on Real Estate Syndications
The vast majority of real estate investors are going to choose a method other than individual syndications. That might be an empire of direct investments, whether they're short-term rentals or long-term rentals. Or it might be a handful of real estate funds or maybe just VNQ. But for a few people, a portfolio of syndications is the right choice. Make sure you're one of them before you buy any.
If you are interested in private real estate investing opportunities, start your due diligence with those who support The White Coat Investor site:
Featured Real Estate Partners
What do you think? Do you invest in syndications? Why or why not? How do you invest in real estate and why?
The post Real Estate Syndications — Who Are They Right For? appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.
