Real Estate Syndications: The What and the Why
Hey. It's Kris Benson from Reliant Real Estate. Welcome to video number 6 on our real estate educational series. Today, we're going to be talking about what a syndicate is and why there are real estate syndications. And by the end of this video, I want to also give you some tips where you can use while you're evaluating individual real estate investment opportunities, specifically around finding out some information about the sponsor of those opportunities.
So, as we had started in the beginning, I think our investors make a decision on whether or not they want to be a passive investor or a direct investor. And I think this video is probably for our passive investors who are looking into passive investing with a real estate operator through a syndication. And so, let's just walk through what that is. I know we've talked about it through the videos a little bit, but we'll get into it a little bit more in depth. All a syndicate is, is a alliance between a number of individuals for the purposes of essentially handling a large transaction that each individual couldn't do on their own.
So, it allows investors or individuals or investors to both pool their money and capital, but also help diversify the risk across multiple people as well. And I like to think about - the best example of a syndication. It doesn't have to necessarily be real estate. We mentioned this in a previous video, but a commercial airline flight is a syndication, right? I personally don't want to spend $40,000 to fly from New York to Orlando, but if I have 200 of my closest friends there, we can syndicate that transaction and we can all pay a little bit to charter the jet and fly to Florida.
So, you know, a syndicate doesn't have to be real estate. It can be anything but the real estate syndication, essentially what happens is, companies like Reliant - we're obviously a self-storage operator, but in any asset class say, hey, Mr. and Mrs. Investor, we're interested in partnering with you on this project. We'll give you this structure to be part of our syndicate and we'll have a whole bunch of individual investors so that maybe you, one individual investor, can't afford it, but if we have 20 or 30 or 40 or 50, that allows those investors to buy a larger project. So, you know, I think, one question that I've gotten from a number of our investors is: are syndications legal and, the answer is yes. So the SEC, the Securities and Exchange Commission allows companies to offer non-registered securities, which is what we're doing through a syndication.
Through - it's called Rule 506 of Regulation D. And, we'll put a link in the video so that you can go on and read a little bit more about that on the SEC website. But essentially, there's two types of 506 offerings. There's a 506(b), as in boy, and then there's also a 506(c) as in cat. And, the big difference between the two is - the 506(b) does not allow the operator or us, let's use Reliant as example, to go and market to investors that it doesn't have a preexisting relationship with.
So, I can't just market to, you know, put an ad in The New York Times for investors in a self-storage facility in Charlotte, North Carolina. I can't do that with a 506(b). So essentially, what it allows people to do is approach the people they already have a relationship with and the SEC is saying, hey, you have two choices of the types of investors you can put into these 506(b) offerings. An accredited investor or a sophisticated investor. And I'll walk you through both definitions.
So, an accredited investor is essentially, there's 2 tests to be accredited. One is a net worth test, which means, you have to have a net worth of over a million dollars, excluding your primary residence to qualify as an accredited investor or the income test is - you have to essentially make $200,000 a year for the last 2 years and expect to make that for the future if you have a single income. And if you have a dual income, then it's $300,000 a year for the last 2 years and expect to make that for the future. And essentially what the SEC is trying to protect against is, investors getting bilked out of their money.
So, you know, if you have the ability to make $2 - $300,000 a year or you have a net worth over a million dollars, the SEC is saying, hey, you probably know what you're getting into. So with a 506(b), just to review, we can have accredited investors or sophisticated investors.
Sophisticated investors is a little bit more ambiguous. Basically, you have to prove that even though you may not hit the net worth test or the income test, you have to prove that you have an understanding in financial matters to be considered a sophisticated investor. So again, 506(b) - no marketing and we can do accredited or sophisticated investors. A 506(c), as in cat, the company that's offering that security can broadly solicit and generally advertise.
So that means, if I wanted to, we could take out an ad in The Wall Street Journal and say, hey, if you're an accredited investor, you can come invest in this storage property in Charlotte, North Carolina. Now, keep in mind, another difference with a 506(c) other than the advertising is, you can only accept accredited investors and think about it. If we're going out and marketing to people who we don't have a previous relationship with, the SEC is trying to make sure that essentially those people know what they're getting into so that we're not, you know, taking people's life savings and stepping it out. And ultimately, the responsibility is on the operator to ensure that our investors are verified as accredited.
And there's a number of different ways we can do that. We actually, at Reliant, use an online investor portal that has a link to a verification service online. And so you would submit your tax returns or something that demonstrates your net worth. And they'll actually submit a letter that says, OK, you know, Kris Benson has been approved as a verified accredited investor.
So, that's the legal structure of syndications. 506(b) 506(c). The the other question that we get a lot of, when we're talking about syndication, especially from investors new to the space is, what is crowdfunding and is that a syndication? And the answer is yes. And let me disclose just as up front, we've done crowdfunding in 3 different offerings with a company called RealtyMogul, which is a crowdfunding platform. We've sold 2. We still have 1. But, just wanted to disclose that to you, the investor. So, my thoughts here, I guess are somewhat biased in that, we've used crowdfunding in the past.
And the difference between a syndication and crowdfunding is essentially, how they distribute the information. So what crowdfunding has done is spent significant amounts of money in their online platform. And so you can see this from websites like RealtyMogul, CrowdStreet, Fundrise. There's a number of these types of websites and they've built a very impressive web platform and a web presence and they maximize their search engine optimization. So, if you're an investor googling "passive income investments", you're probably going to find one of these sites. And, from a difference between syndication and crowdfunding, the only difference is that crowdfunding is using a website to draw investors in, build a big base, and then they'll syndicate deals from operators like us.
So, you know, a crowdfunding site would solicit us or, you know, we would solicit crowdfunding site if we had the need for additional investor money. We would go to the crowdfunding site and say hey, we're Reliant Real Estate Management. We syndicate our self-storage opportunities. We'd like to partner with you to go out with your investors on our next project. And so that's how it works. You know, crowdfunding is essentially connecting the gap between investors who are looking for passive real estate and operators like us who are looking for equity.
You know, I think there's definitely advantages and disadvantages to both. But the nice part about crowdfunding is the platforms themselves will do a lot of due diligence on the operator. So, I just have a list here of a couple of things: credit and criminal background checks on the sponsors or key members of the company that they're putting on their platform. They'll look at the market that you're investing in. Sometimes they'll do an actual on-site visit and go see the property before they put it on the platform. They'll do a review of the sponsors track record and our reputation and review the pro-forma that we've put together - the assumptions and make sure that we're not making any egregious assumptions.
And so, it gives, you know, real estate investors who maybe don't have a lot of experience on how to do that. A little bit of an advantage in that, someone else is checking over their shoulder to make sure it's a good deal. You know, I think, one, I'll go through just the advantages and disadvantages of crowdfunding. I think one of the big advantages is diversification. So, you know, myself as an investor, I can log into a platform, a crowdfunding platform and essentially have access to multiple asset classes.
You know, I can see things from residential, self-storage, commercial, office. There are operators from each one of those, or from many different asset classes, all in one site. So, if my goal is to create diversification in my portfolio, I can get it all from one space and you can decide which projects you want to invest in. You know, I think the other nice piece about it is, unlike a REIT, a publicly traded real estate investment trust, you get to choose which properties you're in. You know, so you can say, hey, I like this apartment community in Alabama. I like this office complex in Phoenix, but I don't like this self-storage facility in Atlanta. So, it's not like you're investing in a fund and don't have any connection to the properties they're buying. You're actually choosing those. And then, you know, I think the other big advantage is, it's convenience and access.
You're on one online platform and you have the ability to access multiple operators all in one space. You know, I think with everything, with good, there's some bad. And obviously, the disadvantages to crowdfunding is, it's more difficult to make the connection with the operator - the people who are actually running the business or doing the investment. And, I'll speak from Reliant's perspective. You know, I think a big thing as you guys are going out and evaluating real estate investments, is having trust in the company that you're partnering with. And it's difficult to do that through the online platforms.
There's a webinar with their team and they'll have some overview, but it's hard to get one on one time with them just because of the sheer numbers. And, you know, I think it's difficult to ascertain who the people are that are running the business behind it. Now, that being said, the crowdfunding platforms incentive is to put good deals on their platform or, you know, they're not going to have a business for very much longer. If they're putting out terrible investment opportunities, that aren't producing returns, investors aren't going to do that anymore. But I think, you know, the incentive of the crowdfunding platform is one that, they want to build their business and put out good properties. But also, how they get compensated typically is for the amount of equity they raise.
And so, they're not necessarily tied to the back-end performance of the property, which, you know, I'm a believer that incentives drive behavior. So,it's important that if my my win is tied to you winning, then I'm probably going to work really hard to win and we're both going to benefit.
And, you know, most of our crowdfunding platforms and I can't speak for all of them, but I can speak for the ones that we've talked to. You know, typically they're getting compensated by the amount of equity that they bring to the table. So their incentive isn't necessarily aligned with the investors, which the investors incentive is to make sure that the operator performs so they get their money on the back end. You know, another one that I always found interesting. There's not really a standardized risk rating for the operators on these platforms. So, you know, the crowdfunding platform will say, hey, this is why we like this operator.
They've done 2 or 3 deals on our platform. Here's their track record. But there isn't necessarily an objective risk of, hey, this is how this company works. You know, here's feedback from other investors we've gotten along the way. And so I think you just need to be careful of that. And, you know, similar to other syndications, there's some disadvantages to the individual private placements, which are, you know, the illiquidity which we've talked about in the past where your money is typically tied up for, you know, call it that 3 to 7 year timeframe.
Each property is a little bit different, but the illiquidity is there and you don't necessarily have the ability to get out of the investment if you need to. So, I think that's the overview on syndication and an overview on crowdfunding. And, let's just assume if you're still watching this video, you know, you're interested in syndications and you say, OK Kris, I could see myself as a passive investor in syndication, whether it be crowdfunding or not. Maybe you're investing directly with Reliant. But, what should I be looking for in the sponsor? And this is the piece that I want to give you some - basically arm you to go out and have some discussions with operators so that you can start to filter. OK. This is an operator I may want to work with. And this is one I don't.
Because, what I can tell you from my own experience is the operator makes or breaks this type of investment. If you have a great operator, they can take an average project and do really well. If you have a poor operator, they can take a project that could be really good and drive it right into the ground. And ultimately, you know, you're trusting them with your time and your money and it's taking you time to build up that money and you can't replace that.
So, you want to feel that the operator on the other side, even though no one bats 1,000. People are going to make mistakes but you want to know that the operator is working hard to get you the outcome that's best and most equitable for everybody involved. So, I'm going to give you a few things to think about and some questions that you can ask a sponsor or an operator to help determine if it's somebody that you want to work with or not. Look, the first thing, and this is probably the most important, is you want to understand their track record.
And, you know, track record is - it's not perfect, but it's a pretty good bet that, you know, what they've done historically is probably going to be a pretty good indicator of what's going to happen in the future. And there's two things in the track record you want to know. Is, 1 - is the asset class that they're selling an investment in now, what they've done in the past. So, if I'm an apartment operator, have I been doing apartments my whole career or am I new into apartments, and I did single family homes before this.
So, you want to understand that. 2 - you want to understand, for the properties that they've sold, what has the rate of return been? What has been the rate of return to their investors? How their investors fared in those individual investment opportunities. And then secondarily, the properties they haven't sold, that they still own, where are they performing based off of projections? So, if they made a projection, two years ago, how is the property matching up based on that original projection? And I think those are some things you need to understand from the track record and also keep in mind - timing.
So, you know, from 2011 through now - I'm talking to you in May of 2019. The real estate market has been incredible for everybody and Reliant has been the beneficiary of that as well. So, if I'm an operator that started in 2012, look, you can't penalize them, but you have to take into account that the market has raised a lot of people up as well. They may not be great operators, but the market around them has supported them and driven returns. So it's something to consider.
Another question you can ask is, have you been through the last recession? So, you know, in 2007, 08 and 09 was, sort of, the last economic downturn we've experienced. Have they been through that and what happened to their portfolio when that happened? Did they lose properties to the bank? Did they have to make capital calls to investors? Those are things that you want to understand before you decide to move forward or not. Another area of key importance is the experience level of the key principals in the deal.
And you want to understand this for a couple of reasons is, you know, 1 -to make sure they know the asset class they're in but also, have they been through a real estate cycle or two? Have they gone through and seen, you know, "the sharks in the water" so they know what to avoid before it happens again? I'm a believer that everything is cyclical. Everything that's going to happen has happened already.
You just need to look back in history to find that. And so, in real estate, it's no different. And you want to make sure the people running the deal have that perspective. You know, this isn't their first 2 or 3 deals where, they may not have that learning experience. And then, a great question, especially in some of the smaller operators is, what happens if a key principal dies? So, we have some - I personally know some operators where there's one guy running the show.
And if, God forbid something happened to him or her - get hit by a bus, the airplane crashes, whatever the case may be, what happens to the company and ultimately your investment? Some things you can look for is key man insurance. Is there an insurance policy that protects them and you that if something happens to them, a big influx of cash would come to the to the company to tie it over, get it through till they can hire somebody to manage it moving forward.
So, I think that's one thing you want to ask. You know, another question is, do you have skin in the game? And skin in the game could mean: are you investing your own money in the properties that you're asking us to invest in? And, the question is, if no, well then, why would I invest in something you're not willing to? Another piece - skin in the game, I think is, the debt.
And I'll use Reliant as an example. In self-storage, specifically on properties where we have construction, we have to sign - the principals of Reliant have to sign on the debt, personally. So that's called recourse debt. And basically that means, if something goes wrong with the property, they're coming after our personal assets to help sustain it. So, you know, skin in the game certainly is cash investment but also, if you're signing on the debt, you're really putting your own neck on the line to make that project work.
Otherwise, they're coming after your own home, houses, cars, that kind of thing, to liquidate so that they can make the project viable. So, skin in the game is a critical piece. Google it. It is an incredible tool and you'll be amazed at what you find if you Google not only the company, but the individuals and the principals and the word "lawsuit" or "suing" or "fraud".
There's a pretty active investment community out there and usually when something bad has happened, there's something on the internet about it. You got to be careful because everything on the internet isn't true. But, Google, you'd be remiss to not do that. And, in some of the investments I've been a part of, we've actually done credit and criminal background checks on the sponsors.
And, we'll pay the money to have that done. If the sponsor pushes back on you at all, probably a red flag for you to be aware of, if they don't want to do that. And I'm not saying everybody has to be perfect. If you're in the real estate business a long time, you'll probably get sued at some point. But you just need to understand what the terms of that were. If you can go to their office.
That's a fantastic way to understand what type of business they're running. Are they working out of their mom's basement or do they have an office on Wall Street? In between, where does that fit? I think it's a critical component to understand. And then, when you actually commit to the investment or are evaluating it seriously, you have to read the subscription documents. That's the contract between the sponsor and the investor.
And so, if the sponsor is putting shady things in the subscription docs and you sign it anyways. That's a shame on you moment. You got to read them and they're not fun. They are in-depth and long and boring. But, you've got to spend the time reading through or pay somebody to read through it who has your best interests at heart to make sure that there isn't anything in there that, would make you take pause or that they didn't represent in their pitch deck - their investment summary or prospectus.
And then, I'm going to include an article in the video where there's a group called the Crowdfunding Review, and they have a fantastic article that goes through what they suggest you should look for in sponsor due diligence as you're evaluating these real estate opportunities. And we'll put that right in the video for you so you can go and read that if you want more information. So, that's all we have on the video number 6 - learning more about real estate syndications and crowdfunding and a little bit more around the questions you should ask an operator for investments that you're evaluating. In our next video, video number 7. We're going to take a look at self-storage as an asset class and give you some of the reasons we think it's one of the pieces that you need to have in your investment portfolio. So we'll see on the next video.