Commercial Real Estate Investing 101: JOBS Act and Syndication
In a previous post, I made the case for including commercial real estate in a well diversified portfolio. Some advantages include high yield, low volatility, low correlation with equity markets, tax advantages, and higher overall returns. In this post, I will discuss background, history, and basic structure in commercial real estate investing.
In general, real estate investments can be considered either active or passive. An active real estate investment requires dedication of time, knowledge and expertise. It can easily be a full time job. An example is owning a single family rental or a triplex. You have to find the property, negotiate the purchase price, secure financing, close the deal, make repairs, advertise the rental, screen and place tenants, manage tenants, and make any repairs if they come up. It can be a lot of work.
With my lack of time and expertise, I decided early on to invest in CRE as a passive investor and leverage the knowledge and expertise of professional private real estate companies. When online real estate crowdfund platforms such as Patch of Land and RealtyShares popped up, my interest was piqued. It seemed to be the ultimate armchair passive investment – high IRR, asset backed, tax efficient, and convenient.
Over the past two years, I’ve allocated a small portion of my portfolio to commercial real estate investments through online crowdfunding platforms and offline syndication deals. Crowdfunding is simply a form of syndication taken to another level through online technology. In the past, real estate syndication was available only to institutions and high net worth individuals. Online crowdfunding democratizes this asset class and many more smaller individual investors can now gain access to these deals. I wanted to test this asset class and various platforms to see if this would be a viable and sustainable investment option.
In the beginning, I made several small test investments on several platforms including Peerstreet, RealtyShares, Crowdstreet, and RealCrowd with mixed results. These investments were made both in equity and debt sides of the capital stack. All of the equity investments are currently active and have not yet cycled. Most of the debt investments have cycled but a couple are in default and I am waiting to see what happens with those. I’ll be detailing more about each of my investments in future posts.
During this time, I joined several real estate investment groups where I’ve gained a tremendous amount of knowledge from more experienced veterans. Networking has also allowed me join several private investment groups and has opened access to off platform private deals. As I’ve gained more knowledge and experience, I’ve ramped up my investment amount and become much more selective with sponsors and deals. More of my investments are increasingly off platform with high quality, best of breed sponsors.
Let’s start off with some basic definitions and general background on commercial real estate investment. I know I know, you all want to see some real deals and numbers, but I want to lay the groundwork first for the novice investor. If you choose to invest in this asset class through syndication and crowdfunding, you need to know the fundamentals.
In 2012, President Obama signed the JOBS Act into law. JOBS stands for Jumpstart Our Business Startup. After the Great Recession, credit markets froze up and this piece of legislation was intended to ease funding of small businesses while opening investment participation to everyday citizens. The JOBS Act is broken down into several titles; the applicable ones are II, III, and IV.
Title II is split into 506b and 506c. Both are Reg D offerings considered “safe harbor” for private offering exemption. This means that companies offering 506 deals don’t have to register their offerings with the SEC, but do have to submit a Form D. There is no limit to the amount of money a company can raise under these exemptions.
Under 506b, sponsors cannot use general solicitation or advertising to market their securities. There must be an existing relationship between the sponsor and investor. Both accredited investors and up to 35 non-accredited “sophisticated” investors can participate. 506b accredited investors can self-verify by attestation alone. Even though up to 35 non-accredited investors can invest in an offering, most sponsors don’t take them. The reason being if one or more of their accredited investors loses their accredited status in middle of the hold period, they can fill one of the non-accredited investor slots and the sponsor will still be in compliance.
Under 506c, the ban on general solicitation has been lifted and offerings can be advertised to the public through any type of medium like the internet, TV, radio, and billboards. However, only accredited investors may participate in the offerings and they must be verified by a third party source. The majority of real estate crowdfunding sites operate under 506c.
Title III, or Reg CF (Crowdfunding) went into effect on May 2016 and opens up crowdfunding to non-accredited investors with strict contribution limits. However, the maximum raise is only around $1 million each year. This limits its usefulness to very small deals and may not catch on in the real estate arena.
Title IV Regulation A+ is a new regulation allowing companies to raise up to $50 million. What is different is this allows the company to solicit the the general public, and allows both accredited and non-accredited investors to participate. Tier 1 allows a maximum $20 million raise. Tier 2 allows a maximum $50 million raise but requires audited financials. There are other strict rules that the company must follow and the entire approval process is generally longer and more expensive. This regulation holds great promise in democratizing investment opportunities to a much larger segment of the investing public. Several real estate platforms like Fundrise, Realty Mogul, and CrowdStreet are now starting to offer public non-traded REITS under Regulation A+.
Commercial real estate asset class encompases a gamut of real estate property types including apartment, office, retail, self storage, industrial, hotels, student and senior housing, and mobile home parks. These assets are purchased by individuals, private equity companies, smaller private real estate companies, and institutional entities like REITs and endowments. REITs and large private equity companies typically purchase institutional grade properties. These are class A, larger, and stabilized core properties that generate healthy cash flow. Purchase price for these assets may start at $50 million and up. Since institutions have billions of dollars to place, smaller properties don’t move the needle and are not worth their time and effort.
Smaller private real estate companies play in this space of properties ranging from $1 million to $50 million. The companies act as sponsors and raise funds from many investors to purchase properties in the form of a syndication. These are the deals that are now seen on online crowdfunding platforms.
Here is a quick rundown of a syndication: A private real estate company is known as the sponsor, operator, or syndicator. These terms all mean the same thing.
Sponsors are the dealmakers; they create the investment opportunity and provide the sweat equity to execute a plan. However, sponsors need equity capital to purchase the property and make the deal happen. The amounts may range from hundreds of thousands of dollars to tens of millions of dollars. The sponsor will syndicate a deal and raise capital from private investors. Private investors are passive investors who are high net worth individuals or sophisticated investors who provide the majority, if not all of the equity capital needed to purchase the property. The passive investor provides the capital, but leaves the heavy lifting, expertise, and day to day operations to the sponsor. In return, the sponsor is rewarded with a promote (carry), which is a cut of the profits from cash flow and a future capital event such as a sale or refinance. The better the property performs, the higher the promote, therefore, there is some alignment of interests of both parties. In addition, the sponsor collects various fees related to the acquisition, disposition, and management of the property.
So what exactly does the sponsor do for their promote?
Their job is to source, underwrite, secure financing, and manage a commercial deal.
Sourcing means deal flow. A sponsor may have a network of brokers to find qualifying deals to fill their pipeline. A good sponsor can get the best deals brought to them before they go on the public market. Out of hundreds of leads, they will cull the stack to a few dozen that meet their criteria and make offers on them. Out of those, they may wind up with several completed deals each year.
The sponsor will crunch the numbers on the deal, inputting various metrics and assumptions, and identifies areas of profitability. This may include value add techniques, lease up efforts, expense cutting, and marketing to increase NOI (net operating income). They create a massive spreadsheet which helps them estimate cash flow, overall IRR, and equity multiple.
Management and Execution:
The sponsor then creates and executes a plan to increase revenue and decrease expenses during the hold period. This may include increasing occupancy, raising rents, and rehabilitating the property. For vertical development deals, the sponsor will obtain land entitlements, obtain financing, oversee construction, sign leases, and ultimately sell or refinance the property. Different property types will have different management strategies. For example, in hospitality, the sponsor will need to put together and execute a property improvement plan (PIP) in order to renew a hotel flag (i.e. Marriott or Holiday Inn).
After a certain hold period of several years, the sponsor will exit the property through a sale or refinance and return the capital to the investors along with the profit if any is made.
Under the organizational structure, the sponsor is referred to as the general partner (GP) and the passive investor is referred to as the limited partner (LP). The entire investment is created under an LLC entity. These deals are put together under Reg D Title II 506b or 506c SEC exemption as private placements. This means these offerings are not registered with the SEC and not subject to its oversight, rules and regulations. Under these rules, investors must be accredited investors as defined by the SEC. The rights and responsibilities of both sponsor and investor are set forth in an LLC operating agreement and private placement memorandum.
Equity syndication investments are illiquid. There is usually a multi-year hold period ranging from 2-10 years and there is no readily available secondary market to cash out or transfer ownership of shares. So the investor is usually in it for the long haul until final disposition. Many investors prefer this arrangement because this money they are investing is not needed for the short or intermediate term. They are willing to trade liquidity for a higher return. (This “liquidity premium” is a subject of debate and may actually be a myth.)
These are but some of the basic concepts of commercial real estate investing. As you can see, there is a lot of moving parts to a syndication deal so it is important for a passive investor to do their due diligence and work with a tenured and experienced sponsor. Personally, I like to see a consistent and good track record through one or more market cycles. I look for conservative assumptions and a well-formulated plan to mitigate risk. Investing in this asset class is not without risk. In fact, it can be very risky. The goal is to limit your exposure to the downside while trying to capture the upside. Until next time, thanks for reading.
Invest in life.
Photo by Mike Wilson on Unsplash