By Adam Carswell
As part of a syndication team that spends ample time educating and answering investor questions, I decided to put together a list of Frequently Asked Questions (FAQs). The following FAQs will serve as a quick study guide for individuals new to investing in this sector. It is also helpful for those who are new to raising private equity and covers what to expect from investors in the way of questions. These are in no particular order, and please note that various types of deals and syndication structures exist. One size does not fit all. I am going to focus on a somewhat unique investment niche that most investors either drive by or utilize everyday … retail real estate (shopping centers and retail stores).
1) What is syndication? Plain and simple, syndication is the pooling of investor money where the investor is most commonly a passive and limited partner. The other partner to the deal is the general partner, or active partner, that puts the deal together and manages the business plan. The objective of the plan is to provide a return for the benefit of all investors. You will hear General Partner (GP), Syndicator, and Sponsor often used interchangeably.
2) What are your return projections and how are your returns calculated? As of this article, industry-standard Cash on Cash (Cash Yield) returns are in the 7 to 10% range, and Internal Rate of Return (IRR) rates are in the 13 to 18% range. In heavy value add deals where there are more development risks, the returns can get much higher. It is also common to see an average rate of return, which is simply the total return over 5 years divided by 5. In value add syndications, the average annual return may be deceptively higher than the IRR. A large portion investor returns come in the year of sale (modeled as year 5). IRR is generally a better measure for varying cash flows over a set time horizon. Additionally, investors will also use Equity Multiple as a measurement of returns. An Equity Multiple is determined by taking the total cash distributions received from your investment and dividing it by your total equity invested.
3) When will I get my original investment back and what is the holding period? Almost always, at the time of sale. For Concordia Realty deals, 5 – 7 years is the target. It could happen in year 3, year 7, or longer if we have a market downturn. However, year 5 is typically what we have as a target.
4) What are the risks? They are outlined in the Private Placement Memorandum (PPM). Each deal has its own unique set of risks. Concordia’s risk management strategies involve underwriting the creditworthiness of the tenants and examining sales for the location, researching the tenant delinquency rate (aging reports and management interviews), submarket vacancy and absorption rates, and the financial health of major employers in the region among other factors. At Concordia, we look at the quality of the real estate location. A good or great location can overcome a lot of negative circumstances that may arise during an investment. Our typical shopping center acquisition has occupancy greater than 90% (sometimes part of our value add strategy is buying with more vacancy and having the relationships with tenants to fill those vacancies). We want to improve well-located properties and part of our competitive edge is experience with remerchandising poorly managed properties in good locations.
5) What is a limited partner (LP)? A passive investor in the deal. They have limited liability. Their risk is limited to the amount they invest in the deal, no more. Their other assets are protected, and they cannot be sued. LP’s have no liability to repay the loan and are not accountable for the active performance of the property.
6) What is the minimum investment? We set ours at $50,000 US with increments of $25,000 US.
7) When will I get paid? Most syndications distribute monthly or quarterly. We aim to distribute quarterly (after closing and the first 90 days of full operations of the property). Funds can be direct deposited into our investor’s accounts. In certain heavy value add properties there might be no distributions in the first year(s). These are more like real estate development deals which are higher risk and higher reward in terms of investment returns. Concordia Realty will always clearly state these types of transactions in any marketing and investment materials.
8) How will you communicate with me? Quick, monthly email updates about the investment’s progress. We use bullet points, and typically pictures of any common area improvements, store openings or aerial photos/drone videos and also income the project is generating, etc. Quarterly property management financials can be reviewed. Following March of each year, our investors receive a K-1 statement from us for tax filings.
9) What kind of tax impact is there? Retail real estate syndications are incredibly tax efficient. As a partner in our limited partnership, investors benefit from their portion of the investment’s deductions for property taxes, loan interest, and depreciation (these are the big ones). We like to use a cost segregation strategy, as well to accelerate depreciation since we customarily hold the asset for a short time. Investors will receive a K-1 statement from the partnership in March of the following year for the current tax year. It’s not unusual for a $100K investment to experience a minimum 8% preferred return, or cash in your pocket of $8K, while experiencing a paper loss on your annual K-1.
Any refinances or supplemental loans are treated as a return of equity, so there are no tax impacts. At the time of sale, there may be an opportunity to 1031 exchange into another property that Concordia Realty wants to buy. This continues to defer long-term gains tax. Remember, some depreciation recapture may occur at the time of sale if a 1031 exchange does not occur. The investor would also be responsible for the long-term capital gains tax. The 2018 Tax Cuts and Jobs Act provided additional tax incentives for real estate investors with 100% bonus depreciation for certain improvements and all Concordia Realty investments are made with a special purpose Limited Liability Company (LLC) which may qualify as for a “Pass-through” deduction. (note: Concordia Realty and the author do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction or undertaking.)
10) What is the process and timeline? Once we have a property under contract, due diligence is about 30 days and closing is usually 60-90 days after contract signing. We start the equity raise process with investors around the contract signing date and that usually runs about 5 to 6 weeks. A marketing deck goes out, an investor conference call takes place, investors reserve a spot, review the PPM, sign, and fund. About 2-3 weeks later we close on the property. About 90 days after closing is the first investor distribution.
11) How do you renovate with retailers operating there? Concordia Realty has extensive experience in renovating and redeveloping operating shopping centers. As experienced operators, we know that no construction should ever take place in the common areas (parking lots, sidewalks, and corridors of malls) during November and December because most retailers do substantial amounts of business during the Christmas season. We also identify tenants located within the shopping center doing above average sales and approach them about expanding. With certain retailers that are doing low volume or not paying rent as agreed, we might agree to a mutual termination to free up space for a better retailer. At all times during a renovation, we make sure tenants have signage and customers have safe access to the stores. A great, low-cost way to make an immediate impression is changing the parking lot lighting to LED fixtures. This not only brightens the parking lot for customer safety but also saves electrical costs and LED upgrades are tax advantage with Federal and State tax codes.
12) What is a sensitivity analysis? We show investors if our forecasts are off. We also like showing the breakeven point for profitability if there is a decline in occupancy, or if rents fail to meet expectations. Most of our financial models allow occupancy to go as low as 75% to break even. We also run several sales and refinancing models to review how the property would perform in various economic environments. Having been in business for several market cycles we know the value of stress testing our deals.
13) Can I use a 1031? Investors cannot 1031 into our deals nor out of our deals. This is because they are technically purchasing units of our Limited Partnership, and not actually the land itself. However, there are mechanisms that allow us to 1031 from one of our deals into another. This defers the tax one would have normally paid on the sale of the first retail real estate property.
14) Can I use a Self Directed Individual Retirement Account (SD-IRA) or solo 401K to fund the deal? Yes, at this time Concordia Realty welcomes these investments. Yet, there is a Unrelated Business Income Tax (UBIT) tax to understand on the SD-IRA, because the US Tax Code is written so that individuals may not take advantage of the leveraged (borrowing or mortgaging) share of the investment. The solo 401K does not have this issue.
15) What happens if we have a hardship and want to get out before we sell the property? There is nothing in our prospectus for an untimely divestment or formula for such a scenario. The investment should be considered an illiquid investment. In more than 28 years of operation, Concordia Realty has never given back a property or been in material financial default on an investment. Concordia Realty has performed workouts (managed, repositioned and sold troubled assets) for banks and insurance companies. Our investors get a partner with deep experience in three (3) significant economic cycle downturns. As a partner with our investors, the general partner would assess issues facing the property to determine the best circumstances for the course of action and disposition.
16) What are your fees? The most important forecasted returns should be post fees. The most common fees with retail real estate investments are the acquisition fee, asset management fee, property management fees, property accounting fees (either included in property management fee or separate from management fee but never double) and leasing commissions. The acquisition fee (normally 2%) is based on purchase price and paid once to the sponsor at closing. This covers all of the sponsor’s costs in finding the deal and putting together the contract. The second most common fee is the asset management fee (also normally 2%) based on monthly revenues. The asset management fee is dependent upon the structure of the general partnership and also for the sponsor to hold the outside property manager (if utilized) accountable, and to ensure the performance of the business plan. Industry averages are between 1% and 3 % for both fees. Concordia Realty Management, Inc. (CRM), established in 1990, is an affiliated property management and property accounting company. The principals of CRM will also be principals with the special purpose LLC investing in the property. Concordia Realty Corporation (CRC), established in 1998, is an affiliated retail leasing company and property brokerage company. Retail leases are complex, multi-year financial agreements that need to be properly structured to obtain maximum value over the term of the lease. These leases can sometimes extend more than 30 years so some great care needs to be taken in the crafting of business terms and granting of tenant rights. CRC works closely with our long-time lease drafting attorneys to craft the optimum lease for the property that also provides a path for success for the tenant. CRC has built positive relationships with quality retails to procure them for our properties. The principals of CRC will also be principals with the special purpose LLC investing in the property.
17) What is a PPM? A Private Placement Memorandum (PPM) is a required by the United States Securities and Exchange Commission (SEC). It describes the offering, risks, partnership agreement, investment summary, and subscription agreement. It is an extensive legal document, normally well over 100 pages. The subscription agreement is what investors review and sign. It includes straightforward information such as the number of units, purchase amount, accredited investor’s declaration form, and other similar criteria. We like to pre-wire new investors if they have never seen a PPM before because the risk section is a relatively heavy (similar to the Surgeon General’s warning). It highlights every possible risk that could happen. We tell investors that there are risks to every investment and that you can lose your entire investment, but certainly, we highlight the stellar track record of MF investments. Keep in mind, no lender is going to give us up to $30mm unless we are experienced, have a worthy business plan, conduct conservative underwriting, have adequate insurance, and have the property condition report completed by outside experts (often 100-pages) which highlights fixes needed in order to take on the property.
18) Are your forecasts conservative? Yes, and they always should be. Good sponsors will under-promise and over-deliver. Evaluate all financial assumptions from the sponsor, and confirm they make sense. Key data points to focus on would be the trade area where the property is located, rents for recent tenants or renewals, sales growth, and financial health of anchor tenants. Check the area vacancy rates and asking rents along with tenant improvement allowance amounts to secure replacement tenants. Review the income statements for the past 3 years, the CAM/Real Estate Tax reconciliations and Property Condition Reports.
19) What if we have a downturn in the economy? We will want to hold in a down market. The goal being the continued pay of the preferred return minimum while waiting for the market to become healthier for a better sale price. Well located properties with strong anchor tenants tend to hold their value since retail real estate leases are written for 5, 10, and 20-year increments. If a property has a lot of lease expirations during a downturn the renewal rental rates could be impacted.
20) What is a Preferred Return? A preferred return (sometimes called a “hurdle rate”) is a minimum threshold return to Limited Partners (passive investors or LPs) before the Sponsor (sometimes called a General Partner or GP) can receive its Split (also sometimes called back-end or back end split) and share of the Waterfall (see below). The preferred return is usually expressed as a percentage return per year, and in most syndications, that rate is usually 6% to 8% per year. The preferred return is never guaranteed and past performance is not an indicator of future returns.
21) What is a Split and what is a Waterfall? The split is the division of the investment returns between the Limited Partners and the Sponsor. For example, if the split is 70% to the limited partner and 30% to the general partner. If there is a preferred return that would be paid first and any returns above the preferred return would be split between the limited partners and sponsors including all other proceeds from distributions or capital events by the percentages of the split (in the example above it would be 70/30). To make things more complicated, a Waterfall is sometimes added to change the Split if specified investment return hurdles are achieved. For example, a 70/30 split can then change to 50/50 split if the IRR on an investment hits 17%. Any returns higher than a 17% IRR, will then be split 50/50 between the limited partners and sponsors. We have seen some institutional transactions structured with 2 and 3 waterfalls. In our opinion, for most deals, a waterfall is unnecessarily complicated and we try to structure our deals in a simplified manner with a preferred return and a simple back end split.
22) What is an Accredited Investor? We currently market our deals under SEC regulations 506(b), meaning we can only share our deals with investors who are accredited. We also must have a relationship with them. The definition of accredited in the U.S. is a person earning $200K per year, or a couple earning $300K per year over the past two years with the expectation to do so in the current year. Also, an individual with a net worth of $1mm (excluding primary residence) qualifies as accredited. Since we do not advertise our deals, the accreditation determination is made via self-disclosure of the investor by a checkbox. If the deal is advertised to the public, then verification by a separate third party is required.
23) Do Sponsors (Syndicators) invest in their own deal? Yes, you would want a sponsor to risk their own money in order to align with investors. When the Sponsor (GP) invests, their money goes with all other investors money into the LP investment bucket (70% split) and the investment returns are distributed pari-passu (side by side or on equal footing). Then the Sponsor split of 30% is what the sponsor or GP has earned for arranging the deal and doing the work necessary to achieve the returns. We put money in the deal as a vote of confidence and incentive to work as hard as possible to achieve the desired outcomes.
About the Author: Adam Carswell
Adam J. Carswell is a real estate entrepreneur, new media marketer, and podcaster. Carswell committed his career to real estate in 2015. Within his first year-and-a-half in real estate, he closed over 25 transactions with RE/MAX in Washington, D.C.. Carswell currently resides in the Bay Area of California. He serves as Director of Media and Marketing for Concordia Realty. Adam creates educational content and is responsible for the management of investor relations. Additionally, Carswell plays a major role in the Concordia Realty acquisitions committee.
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