Only rarely will a lender cover 100% of a property’s cost. Lenders generally want owners to retain some “skin in the game.”
But you may not have enough cash (or don’t want) to cover the rest of the money needed. In these cases, investors need to look for other investors to share in the ownership (and the upside) of a real estate project.
This is particularly important on larger commercial properties – those usually involve larger price tags than a single investor wants to take on alone. Even the largest real estate companies usually use shared ownership “syndicates” of other investors to cover the financing not covered by the lender.
The small industrial property below is something I invested in myself. The sponsoring real estate company is a prominent one, handling value-add industrial projects throughout the Midwest. Like most companies, though, it prefers to spread its own funds over several projects – so it invited other investors to share in the financing of this one.
My industrial property investment – hope it works out ! – Lawrence Fassler
Most of these “equity” real estate investments are structured through “direct participation” investment vehicles like limited partnerships or limited liability companies. These structures not only give you the benefits of passive investing, they also allow for the “pass-through” of depreciation, interest expense and other deductions that that can reduce your taxable income. Thus, you get all the tax and other benefits of owning real estate without being an active, direct investor – so you won’t have to spend all your time searching for (and then managing) these investment properties.
The new “crowdfunding” companies enable investors to get in on these projects at lower minimum investment amounts than had previously been available. Investors using the company I work for, for example, will usually invest alongside a professional real estate company often called a “sponsor” or “operator” that will find a viable project and perform the related management chores once the property has been acquired. Other investors (like you or me) provide some of the investment capital required for that opportunity – and these investors will then share in some of the project’s benefits (and risks).
Although limited partnerships are sometimes used, most real estate investments are structured using limited liability companies. These entities not only provide limited liability to the investing members (and usually the sponsor), they also allow for the “pass-through” of tax deductions that derive from the ownership of real estate.
The structuring issues then come down to how to divide the financial benefits of the project among the investing members and the sponsor. (Investors also want to know that a sponsor contributes at least 5 percent to 10 percent of the equity capital for the project, so that it has sufficient “skin in the game” that its interests are aligned with the investors.) For investors, a partial risk/benefit analysis might include the following:
The negotiations involved in resolving these issues vary with each transaction, depending on the anticipated risks and benefits involved in the particular project. Over time, however, some common patterns have emerged for many transactions:
Limited Members:
- Provide the vast majority of the capital (usually 80 percent to 95 percent)
- Receive a “preferred return” on their investment (often 5 percent to 10 percent annually)
- Receive a share of the remaining cash flow and profits (typically 50 percent to 80 percent)
- Receive the bulk of the tax benefits, such as depreciation and interest deductions
Sponsor:
- Provides a small portion of the capital (usually 5 percent to 20 percent)
- Receives the same preferred return as investors on its own invested capital
- Receives a “promote” share of the remaining cash flow and profits
- May receive fees relating to property acquisition, loan financing and management
- Receives some share of the tax benefits
How to look for other investors to share ownership for additional funding
Investors putting cash into a project also generally receive some “preference” in the return of that money before any “sweat equity” gets compensated. The preferred return, often in the 6 percent to 10 percent range, means that the investors will receive that amount before the sponsor gets paid any “promote” share of distributable cash flow.
The preferred return is not a guaranteed dividend, however. Sometimes the preferred return is not paid out because the property cash flows don’t allow for it (for example, where the property is still under development). In such cases, the preferred return typically continues to accrue, and any unpaid amounts should ultimately be recouped by the investor when the property is sold.
Real estate investment opportunities can be structured in many different ways. For example, pools of real estate properties can be owned through real estate investment trusts (REITs). The use of pass-through entities (like LLCs), however, can make real estate investing much more attractive. Those structures allow passive investors to take advantage of many of the tax advantages of real estate ownership in a way that REITs do not. Guess what we’ll be focusing in a subsequent article?
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