How to Diversify Your Investments and Build Wealth through Real Estate Syndication Investments 2018-01-04T13:34:18+00:00

How to Diversify Your Investments and Build Wealth through Real Estate Syndication Investments

If you’re an investor looking to add real estate to your investment portfolio, you’ve come to the right place. Real estate is an essential piece of a strong portfolio, but like all investments, there are the certain strategies that investors can use to make the best returns.

We’re going to show you why real estate syndication offers a unique way for investors to gain access to the real estate markets. But first, let’s take a look at how real estate investments can beneficially impact your investment portfolio.

1. Importance of Diversifying your Portfolio

All investors have heard wealth managers preach the classic investing cliche: “The number one rule for investing is diversification.”

The more common phrase is ‘Don’t put all your eggs in one basket.’

But why is this so important? Because a well-diversified investment portfolio reduces your risk as an investor.

How Does Diversification Lower Investment Risk?

Each investment you make carries some risk that you will lose your capital. For example, if you own stock of a business, there is risk the business goes bankrupt or share prices go down.

The same goes for real estate. If you own real estate, there is risk to your capital if the property is damaged or devalued for some reason. With real estate, investors can effectively mitigate some of their risk by partnering with real estate investment companies. We’ll highlight a couple different ways to do that later.

Diversity in an investment portfolio means the investments are spread across different asset classes. This gives the investor exposure to different areas in the economy and allows for a robust portfolio.

In the event one asset loses value over time, a diversified investment portfolio won’t suffer dramatically because the other assets are factored in as well. The main objective is to structure your assets in a way that no one thing can bring down the entire ship.

The diversification effect can be illustrated with a simple example.

Diversification Effect

Investment Portfolio ‘A’ has $100,000 of capital invested evenly across two different assets: ‘Asset Y’ and ‘Asset Z’.

Investment Portfolio ‘B’ has $100,000 of capital invested evenly across twenty different securities: including both ‘Asset Y and ‘Asset Z’.

‘Asset Y’ is not very volatile and holds steady. Its value doesn’t change throughout the year.

However, ‘Asset Z’ was a risky investment. By the end of the year, it loses all of its value and goes to zero.

Let’s look at the effect of our risky ‘Asset Z’ on each of the Investment Portfolios and see which one performs better. (This assumes all other investments remain constant.)

Investment Portfolio ‘A’ lost the entire investment in ‘Asset Z’. At the end of the year the remaining capital is $50,000.

Investment Portfolio ‘B’ lost the entire investment in ‘Asset Z’. At the end of the year the remaining capital is $95,000.

Here we see that the well-diversified Investment Portfolio ‘B’ is the clear winner. By having investments spread across twenty different assets, even the huge loss of ‘Asset Z’ wasn’t enough to dramatically damage the overall portfolio.

Why is this important?

Turning our attention back to Investment Portfolio ‘A’, other than losing money, what are the ripple effects of the non-diversified portfolio?

Well, now Investment Portfolio ‘A’ only has $50,000 of capital to put to work making returns in the future.

Let’s see how the scenario might play out in the next year.

Investment Portfolio ‘A’ has $50,000 of capital invested.

Investment Portfolio ‘B’ has $95,000 of capital invested.

Let’s assume the next year was a little less volatile, and each Investment Portfolio made a nice 10 percent return. Now let’s see how that impact each portfolio.

Investment Portfolio ‘A’ gained $5,000 with an overall total of $55,000.

Investment Portfolio ‘B’ gained $9,500 with an overall total of $104,500.

As you can see, both portfolios had the exact same 10 percent return. But because Investment Portfolio ‘A’ wasn’t diversified and lost a larger chunk of the nest egg, any future returns are relatively diminished.

Bottom Line: Not only does a losing investment severely impact a poorly diversified investment portfolio, it hinders the portfolio’s ability to make larger returns in the future.

2. Different Ways to Invest

Now that we’ve examined the effects of diversification on your investment portfolio, choosing your asset allocation is the next step. Asset allocation simply means choosing which asset classes to invest in (i.e. stocks, bonds, gold & silver, real estate, cash, etc.), and how much capital to invest in each.

Let’s take a look at a few different types of assets for investments.

Stocks: A stock is a type of investment that represents ownership in a company or business. Stocks are also commonly referred to as ‘shares’ or ‘equity’ in a business. Stocks give investors the right to their share of the company’s earnings or assets. Investors can own stock in public or private companies. Owning stock in a public company means you can buy and sell the shares on the open market over a stock exchange. Stock in a private company is bought and sold directly between the parties involved.

Bonds: A bond is a type of fixed-income investment. An investor loans money to the borrower (usually a corporate or government entity). The borrower pays back the loan over a predetermined time frame along with an interest rate. Bonds are liabilities for the borrower, and in the event of bankruptcy, bondholder investors are typically the first stakeholders in line to receive payment (before shareholders of stock).

Real Estate: The term real estate in the investment world refers to real property. This includes land, buildings, and various improvements to the property, along with the right to use the property. Ownership is a key aspect of real estate, just like stocks and bonds. Investors can own real estate and use it accordingly. Residential real estate refers to property such as homes, apartments or condominiums. Commercial real estate refers to office buildings, retail space or warehouses. Industrial real estate refers to farms, factories or mines.

Stocks, bonds and real estate are three primary asset classes in any well-diversified investment portfolio. Each one has key drivers that affect whether the asset value rises or falls. What makes them complementary components in an investment portfolio is they don’t share the same key drivers.

In other words, factors that affect real estate are different than those affecting stocks or bonds. Back to the adage of not allowing one thing to bring your entire ship down — there shouldn’t be one thing that negatively impacts all three assets to dramatically harm your investment portfolio. That’s the power of diversification.

Now that we’ve taken a quick glance at the different types of investments, what kind of yields can you expect as an investor with each asset class?

Here is the breakdown of 20-year average returns for stocks, bonds, and real estate in the U.S.:

  • S&P 500 Index average return: 8.6 percent
  • 20-year Treasury note yield: 2.67 percent
  • Diversified real estate investments: 10.6 percent

Each asset class has its benefits and disadvantages. However, over the long term, real estate investments outperform the overall market.

But by now you may be asking, “Well I can basically buy stocks and bonds with the click of a button these days. How can I get access to real estate investments?”

That’s what we’ll discuss next. We’re going to take a look at real estate syndication as an investment vehicle for real estate and why it’s a good option for investors.

3. What is Real Estate Syndication?

When it comes to real estate investments, many investors find themselves facing common obstacles:

  • Not enough capital to fund an entire project
  • No time to manage the daily operations for the project
  • Not enough experience to generate the best returns

Real estate syndication aims to help investors overcome these issues.

Real estate syndication is the process of pooling together capital from multiple investors to fund real estate projects. It gives investors the opportunity to invest in properties and projects they couldn’t access alone.

Comparing it to the stock market, participating in a real estate syndication is similar to buying shares or equity in a business. But in this case, investors are buying shares or equity in real estate properties.

4. How Does the Syndication Process Work?

Real estate syndication usually involves two parties: sponsors and investors.

Sponsors are tasked with quarterbacking the project’s operations and activities.

Investors are tasked with funding the project.

Let’s draw up another simple example to explain how this works.

Bakery Example

Joe and Amy decide to start a business. Joe makes the best cakes in town and Amy has money she is looking to invest. Together, they make a great partnership.

Joe contributes the sweat equity: He bakes cakes and manages business operations every day.

Amy contributes the financial equity: She puts up the money to fund the business.

Both Joe and Amy bring value to the business and in turn have equity. This means they share in the bakery’s profits and each have ownership of the business.

Real Estate Syndication Example

In this example, Joe represents the sponsor’s role, while Amy plays the part of the investor.

Sponsors and investors both want to generate returns from real estate investments. Sponsors have the expertise in finding the best investment opportunities in the real estate market. Investors have money they are looking to invest. Again, we have a great partnership in the making.

Sponsors contribute the sweat equity: They identify investment opportunities and manage the operations for the property.

Investors contribute the financial equity: They put up the money to fund the real estate projects.

Like the bakery example, both sponsors and investors bring value to the syndication and thus share equity in the property along with the returns.

5. Types of Real Estate Syndication

Real estate syndications often take the form of a Limited Liability Company (LLC) or a Limited Partnership (LP). This type of entity gives investors a liability shield, so their maximum risk is the capital invested into the syndication.

There are two primary ways to participate in a real estate syndication: equity syndication or debt syndication.

Let’s take a closer look at each.

Equity Syndication

Equity syndications operate much like a business, as in our bakery example.

Each party, sponsors and investors, provide value to the syndication for equity in the project. Sponsors bring the expertise, while investors bring the money. Both get their fair share of ownership in the property and its profits.

As an investor, you can imagine the property like a business. You invest a certain amount of capital for a certain percent stake in the property. The property has an underlying value that rises or falls based on the market. The property also has the ability to generate returns through rental income.

Investors see the rental income much like a shareholder receives a dividend based on how well the business performs over the year. When the project is finished, the property can be sold and investors take their share of the value.

Real estate syndications usually offer a few different types of equity offerings to investors:

Specific Offering: This is the most common type of offering for equity syndications. Sponsors find a specific real estate investment and market the opportunity to investors. Investors can analyze each offering and the property involved to estimate the expected returns. If they believe in the specific property or project, they can choose to invest.

Semi-Specific Offering: In this situation, sponsors find various properties that are potential investment opportunities. They present those opportunities to investors, highlighting similar properties in a business plan to provide credibility for the returns. Instead of funding a specific project, sponsors are looking to use the business plan to raise more funding for future projects.

Blind Pools: In this case, sponsors start with a proposed business plan for future real estate projects. No specific properties are mentioned, however the goal is to establish the process for identifying and executing future real estate deals. Investors are ‘blindly’ buying into the sponsor’s vision and betting on their experience and expertise with prior transactions.

Debt Syndication

Debt syndications operate much like bonds.

Investors make a loan to the borrower for the purpose of financing real estate investments. The borrower pays back the loan over a predetermined time frame in regular payments, along with the interest rate.

Similar to other bond options, debt syndications offer investors a fixed return and interest payment. Lenders can choose the time frame of the loan — short-term up to a year, or long-term for years or decades.

In real estate investing, there are several different loan offerings for investors:

Mortgage: The most common type of debt offering in real estate is a mortgage. Many homeowners are probably familiar with mortgage as a form of debt. In mortgages, the property purchased by the borrower serves as collateral for the loan as the borrower makes predetermined payments. Mortgages are usually a longer-term loan and can last years or decades.

Bridge Loan: Bridge loans are shorter-term, and are used to bridge the gap until the borrower secures a permanent financing method. Like most short-term loans, bridge loans come with a higher interest rate to the borrower and are usually paid back in under one year.

Hard Money Loan: Hard money loans come into play when the borrower is in a tough situation. Often times they are battling foreclosure on a highly valued property. These loans are solely backed by the property’s value, with no account taken for the borrower’s credit history. These loans carry the most risk and are most often made by private investors.

What’s the Difference?

Now that we’ve looked at both equity and debt syndications, and explored the investment options within each, what are the key factors to account for as an investor.

Risk: Using debt in real estate investments carries less risk for the investor. Like corporate bonds, if the investment goes belly-up the debtholders are the first in line to get reimbursed.

Equity investments have more risk because there is a greater likelihood of losing capital, or in the worst case the entire investment. Just like buying stock of a company, if the company goes bankrupt, investors lose their capital investments.

For example, if the property behind the loan is foreclosed, debtholders will get their payment and if anything is left at the end, equity holders split the rest.

Return: Debt investments are fixed income investments for real estate investors. Borrowers make quarterly or annual payouts to their lenders with a pre-specified interest rate.

This is where equity-based investments have room to shine in the real estate market. The returns carry much more potential with equity, and they are directly related to the property’s value and earnings potential.

Real estate equity investments have plenty of upside potential while debt investments are fixed. Equity can reward investors who make good business decisions and increase the value of the property. Debt can provide investors with a consistent return.

Liquidity: The liquidity of equity and debt investments in the real estate market is determined by how the investor chooses to structure their investment.

Debt investments are typically seen as more illiquid investments. Loans can have longer terms which means less liquidity for the investor. Shorter-term loans can increase liquidity levels, but at the expense of more risk on behalf of investors.

Equity investments can be fairly illiquid as well when it comes to long-term projects. But there are various ways for investors to increase their liquidity on the equity side. Participating in a real estate syndication and owning shares of a property can allow for more liquidity. Other ways, like buying a REIT, offer the same liquidity as owning a stock. More on comparing and contrasting REITs and syndications below.

6. Advantages of Real Estate Syndication for Investors

Now that we know a little bit about real estate syndications and how the process works, what is the advantage for you as an investor?

High Yields

We discussed this earlier, but to revisit the numbers, real estate is known for providing investors with the potential for higher yields than other typical investments like stocks and bonds. The 20-year average returns for each asset is listed again below:

  • S&P 500 Index average return: 8.6 percent
  • 20-year Treasury note yield: 2.67 percent
  • Diversified real estate investments: 10.6 percent

Unattainable Projects

Many investors struggle when it comes to real estate investing because they don’t have all the skills or resources to see a project through to completion. They might not have the capital to fund the entire project alone. They might not have the experience to identify and effectively facilitate a real estate transaction. They might not have the business acumen to run the project and generate the best returns.

Real estate solves all those problems for investors. Investors only need to contribute a capital amount comfortable for their investment portfolio. The sponsor takes care of the rest. This allows investors to participate in real estate projects larger than they would otherwise invest in on their own.

Basically, real estate syndication opens up real estate investing to the average investor.

Passive Investor

With real estate syndication, investors can participate as a passive investor. They don’t need to have the experience or expertise in real estate to be successful with their investments.

This is huge advantage for investors who prefer stock-type investments, where they get to act as a minor shareholder and let the management team run the business operations. The investors simply get to own shares of the real estate property and participate in the returns.

In real estate syndication, investors are hands off. The advantage they have is leveraging the real estate investment company’s management team and their success in the real estate markets.

Diversification

This is a huge benefit for investors in a real estate syndication. First off, it gives real estate investors easy access to real estate investments, thus giving investors an easy way to add diversity to their investment portfolio through real estate.

On top of that, real estate syndication allows investors to further diversify their real estate portion of their investment portfolio by giving them access to different types of properties in the real estate market.

Investors can participate in syndications for high-end commercial real estate, apartment buildings, office space, industrial properties like timberland, etc. Different factors impact the property prices within the real estate market, and syndication allows for investors to spread the risk across the entire real estate market rather than isolating their investment in one segment or niche.

Tax Benefits

Another notable advantage for investors is the tax benefits provided by IRC Section 1031: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

The 1031 exchange allows investors to defer capital gains tax by reinvesting that capital gains in another property. The advantage here mirrors that of a 401k. Investors can defer taxes and keep the maximum amount of capital invested to earn returns.

Another very quick example to illustrate the benefit:

You sell a property and realize a capital gain of $100,000. Let’s assume a simple tax structure that taxes at a rate of 25 percent.

Scenario A: You get taxed $25,000. You now have $75,000 to invest. Your next real estate investment returns 10 percent next year. Your return is $7,500.

Scenario B: You defer the 25 percent tax. You reinvest the full $100,000. Your next real estate investment returns 10 percent next year. Your return is $10,000.

Deferring taxes gives investors the opportunity to earn higher returns on their capital investments.

Tangible Assets

Real estate syndication gives investors ownership of a tangible asset. This dovetails a bit on the diversification benefit. As an investor, it diversifies your asset base.

When you own a stock, you have partial ownership of the company’s assets and future earnings. But those aren’t necessarily tangible assets and the earnings aren’t certain.

When you own a bond, you really own an “I Owe You” from the borrower written on a piece of paper. It’s a promise of future payment.

Tangible assets always carry economic value. Other examples of tangible assets include precious metals like gold and silver, or currency like the U.S. dollar.

However, gold and silver don’t provide investors with any sort of return. And the dollar’s value is perpetually declining over time. The Federal Reserve notes that the purchasing power of the dollar has declined 96 percent since the FED came into existence in 1913.

Real estate gives investors another tangible asset to own and hedge against other assets in their investment portfolio.

7. What is the Difference Between a REIT and a Real Estate Syndication?

Earlier we mentioned REITs along with real estate syndications as a way for investors to gain liquidity in their real estate investments. But what exactly is a REIT, and how is it different than a real estate syndication?

REIT (Real Estate Investment Trust)

A REIT is a type of security designed for investing in real estate markets. REITs are companies that will typically purchase properties or mortgages to gain exposure to real estate.

REITs have similar characteristics to mutual funds. Often times they’re traded on the stock exchange along with other publicly traded companies. This is where the liquidity factors in; investors can take part in a REIT by simply purchasing shares of the company through their investment account.

This gives investors exposure to the real estate investments made by the REIT. REITs can often focus on a niche area of the real estate market — i.e. office buildings, shopping malls, hotels, factories, etc.

Types of REITs

Like real estate syndications, there are several types of REITs for investors to familiarize themselves with.

Equity REITs: This is the most common type of REIT. Equity REITs buy, sell, and own property. Their revenue and income is derived from leasing the property and collecting rent from tenants. The rental income is distributed to the company’s shareholders as a dividend. When properties are sold, the proceeds are either reinvested or distributed as dividends.

Mortgage REITs: Mortgage REITs are less common, but they buy, sell, and own property mortgages. One common way to purchase mortgages is through mortgage-backed securities. The interest rate spread is the key driver of revenue for mortgage REITs. They are highly sensitive to fluctuations in the interest rates for mortgages.

Hybrid REITs: Hybrid REITs engage in buying, selling, and owning both properties and mortgages.

8. REIT vs. Real Estate Syndication Comparison

With the basis of what a REIT is and how it operates, let’s turn our attention back to the comparison to real estate syndications.

Both REITs and real estate syndications serve as vehicles for investors to invest in real estate. Similarly, they provide investment exposure to the real estate markets and offer diversification for investment portfolios.

However, investors should understand the key differences between a REIT and syndication. The primary differences are in the size and scope of the projects.

REITs generally take on projects with the intent of holding long-term. As discussed, REITs are commonly found traded on the stock exchange with robust dividends. However, with the exposure to the stock market, share prices tend to reflect a struggling economy. For example, the average REIT saw their share price fall between 40-70 percent during the recession from 2008-2011.

Real estate syndications have fewer legal restrictions attached, as they aren’t traded as public companies. They typically focus on fewer overall projects and have a shorter time frame for their property holdings.

With that, real estate syndications are able to offer a direct investment approach for the real estate market. Investors directly participate in the ownership of a specific real estate property and returns from the project.

Investors have the opportunity to analyze specific offerings from a syndication and choose which investment fits their personal criteria. Then they get to leverage the syndication team to make the project become a reality.

9. Why You Should Work with a Real Estate Investing Company

We’ve established the importance of a diversified investment portfolio, and why real estate is a crucial asset class for investors. We’ve also examined effective ways for investors to gain exposure to the real estate market through their investments.

Now we’re going to close with the reasons why you as an investor should take advantage of working with a real estate investing company.

Pooled Capital

Entering the real estate markets on your own is a tough game. Going solo limits the type of property and scale of the project you can undertake. Working with a real estate investment company eliminates those limitations, and joining a syndication gives investors access to a multitude of projects.

Leveraged Expertise

If you’re taking the real estate journey alone, you’re immediately tasked with finding viable investment opportunities, developing and project plan, and conducting the transaction. Past that, all business operations are up to you.

With a real estate investing company, you are expected to contribute the expertise. You as the investor are simply the money part of the equation. Real estate investing companies have the teams in place to identify and conduct lucrative investment opportunities in the real estate markets.

Avoid the Dirty Work

If you’re new to the real estate game, expect a quick education if you decide to move forward on your own. The so-called ‘dirty work’ of managing the property and the day-to-day activities can quickly add up to a full-time job.

That’s why real estate investing companies make it someone’s full-time job (or several people). They handle all of the managerial responsibilities associated with the property – i.e. paperwork, rent collection, property management duties, etc. You get to play the role of passive investor and collect returns as the project progresses.

Property Appreciation & Rental Income

Real estate investing companies have a track record of prior deals and projects they’ve completed in the past. You can analyze their past performance and estimate the return you could expect to see on your investment.

As an investor with a real estate investing company, and especially with a real estate syndication, you are positioning your investments to make returns from both rental income throughout the life of the project and property appreciation upon completion.

Bottom Line: With a positive track record and good income projections, real estate investing companies can offer investors a peace of mind in their real estate investments.