Investing as a Limited Partner - What to Know?
by Christopher Levarek
“Knowledge is not power, it is only potential. Applying that knowledge is power. Understanding why and when to apply that knowledge is wisdom!”
- Takeda Shingen
Investing into real estate can be different for the average W-2 earner then what they are used to. Traditionally most W-2 investors only understand or know investing through the use of stocks, bonds mutual funds, index funds or simply letting their “retirement plan” do the investing for them. However, an alternative to such investments is the path of investing into “syndications”. If you are new to the term syndication check out our blog here on the subject in depth.
These syndications, a partnering of people and resources to buy real estate, are in general similar frameworks to existing companies/stock holders found on the Stock Exchange. Syndications are composed of General Partners (managers) and Limited Partners (investors). Limited Partners invest into the syndication for ownership, returns, tax benefits and the General Partners manage the investment to deliver upon the business plan of the syndication.
Ok, so what should a limited partner be aware of? What is important to understand for investing into a syndication? Why would anyone invest into a syndication?
Not all Syndications are Created Equal
Asset Class
A syndication can be done on multiple types of real estate assets whether apartments, mobile home parks, self-storage, senior-housing, student-housing, development, etc. Assets vary but the principal is the same and that is to purchase a real estate asset with investor and general partners capital/work to deliver a return/benefit.
However, the asset class of the investment is very important to understand for the investor. Investing into a “new development” project might not yield any kind of return for the first year. Why? It is fairly obvious that if the property is not yet built, it can’t really collect rents and therefore can’t pay investors as easily. So asset type of the syndication is important to know for an LP and the overall pros/cons of the business model of said asset should be understood.
Syndication Legal Entity
Syndications are typically completed using something called Rule 506 Regulation D Exemptions. In brief, companies usually have to register as a “seller of securities” and pay large fees to be able to raise capital for investments but these exemptions allow smaller enterprises the ability to raise capital without such costly/lengthy requirements.
However for the LP, it is important to note which type of entity is being created for their syndication. The 506B and 506C are most common and have implications to the LP. In general, a 506B allows 35 non-accredited investors where as a 506C must be all accredited investors. Depending where the LP is positioned financially will determine if the syndication is a good fit or if they qualify. See our blog post on what the qualifications are.
Tax Liability & Benefits
Many investors turn to real estate for the amazing tax advantages available with these investments. The tax code encourages investments into real estate because this in turn helps the government and economy overall, read Tax-Free Wealth by Tom Wheelwright to understand this.
With syndications, it is important to find out if the General Partners plan to perform a cost-segregation study. This will accelerate tax depreciation losses to be realized in the first year or over 3-5 years instead of 27.5 or 39 as is typical in real estate. This can be very important for the LP looking to get a loss or tax depreciation in a specific year so it aligns with their financial position if for example they had a large gain the same year.
Investor Returns
Often the first item that an investor is looking for is a return on investment for the real estate syndication. If the return promised is higher than 10% this must mean it is a good investment when compared with index funds or traditional stocks, Right? As always…It depends.
Here are a few items worth knowing as a Limited Partner to understand if the return promised is meeting their need :
What is the annual scheduled ROI for the 1st year, 2nd year, 3rd year? What is the overall return?
Understanding the initial return in the first few years will ensure there are no surprises. Many syndications are back-loaded, meaning the majority of return comes at the end of the deal.
How much of the return comes from cashflow, or property income and how much comes from the sale of the property at the end of the syndication (very typical to sell in 5-7 years.)?
Again important to understand if the property is really performing with cashflow or simply from a sale at the end.
Is there a preferred return?
This return ensures investors are prioritized and paid out before any GP receives a cut.
A whole book could be written on the right questions to ask and in fact, we recommend looking into Brian Burke’s book, “The Hands-Off Investors Guide to Investing in Passive Real Estate Syndications”. The main point on returns we want to drive home is that, understanding the business plan is important. A return is only a number and the Limited Partner should ensure they understand how that number was reached or at the very least if the delivery schedule/method aligns with their interests as well.
SDIRA or Solo 401k
Many investors choose to use their self-directed retirement plan to invest into real estate projects. This can greatly benefit the plan due to the substantial returns possible through real estate which can not easily be matched in mutual funds to any degree.
If this is the case for the LP, it is obviously important to find a Syndication that allows such an investment type. The syndication typically has to have a specific type of shares that allow this type of investor or the GPs have to be familiar with these investments. Tax deferment or depreciation may not be possible if the investor is already not being taxed on the funds in these accounts.
Documents, Deadlines, Expectations and more...
As a Limited Partner, you are becoming a owner and partner of real estate and a business owning real estate. It is paramount you understand the documents you are signing, the date requirements of the signing of any documents, wiring of funds and closing dates of the property.
Ensure you read the documents in full and raise any questions to the General Partner team as early as possible.
Understand if you are investing into a fund or simply a single property. If it is a fund, what type of other real estate will be purchased with the fund?
Understand if the documents will be signed online via an investor portal or Docusign or if you will need to physically sign and mail in your check/documents.
Understand if you are receiving your return in the mail or by direct deposit.
Understand how to exit the deal and when an LP would be able to pull out their capital in case of emergency.
If using a SDIRA/Solo401k , understand the timeline to have funds sent to a Syndication account. Often these are lengthier processes then simply withdrawing from a Savings account.
Are you interested in becoming a Multifamily Syndicator or learning the investment behind the scene? Perhaps align with a Syndication that allows or encourages an LP to tag along and learn the ropes instead of simply investing for the return/tax benefits.
In Final
Investing into syndications is a great method to achieve some highly beneficial advantageous which are simply not available in traditional investments. Mainly these include tax benefits through depreciation, higher returns, greater control/visibility and forced/natural appreciation of assets.
However it is up to the Limited Partner to align with a syndication that meets their needs and furthers their specific goals. Performing due diligence on partners and the business plan will greatly benefit the Limited Partner as well as the partnership as a whole. Invest Smart!