Summary: If you’re thinking about real estate syndications, an important part of the vetting process is asking the deal’s sponsors really good questions. But for those who have no experience in real estate investing, how do you know what questions to ask? This article doesn’t cover the softball questions; instead, we give you five hard questions – the types of questions real estate syndicators don’t want you to ask.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
If you’re considering investing in a real estate syndication, it’s essential to properly vet the deal to know where you’re putting your hard-earned money.
To vet a deal properly, you will want to ask the general partner (GP) or deal sponsor questions about the agreement. However, it’s hard to know what questions to ask if you’ve never invested in real estate. Fortunately, we have deep experience investing in real estate. Leti and I have been investing in real estate for a combined 29 years, and we own over 150 apartment units, and we’re GPs on another 424 units. So, we’re well positioned to know what questions you should be asking.
Now, we’re not going to cover the easy questions – the types of questions you can get from any article on the internet. Instead, we’re going to cover the really hard questions. The types of questions real estate syndicators DON’T want you to ask.
Before diving into these questions, you may want to check out our other articles in this series.
Basics of real estate syndications covers the basics. It’s a good starting point if you want to learn more about syndications.
How much do general partners in real estate syndications make gives you insight into just how lucrative it is to be a GP. Before you invest, you need to know just how much of an incentive GPs have to sell you on a deal and how they are paid. You’ll find that a good portion of the money they make is earned regardless of performance.
How to become a general partner in a real estate syndication covers the two paths to becoming a general partner in a real estate syndication.
Now let’s get into the questions:
Are you putting money in the deal? If so, how much of it is from the acquisition fee?
General partners often advertise that they are putting “skin in the game. “It’s meant to reassure you that they’ll take good care of your money because they’re risking their money too.
But the question is, are they really risking their money?
Keep in mind that general partners earn multiple fees. If you want to learn more about these fees, CLICK HERE.
One of these is an acquisition fee. The fee ranges, but it’s normally 1-5% of the purchase price. So, let’s assume an acquisition fee of 2% and a purchase price of $20 million. The acquisition fee alone is $400,000. If you add some of the other costs on top of this amount, the total fees could be considerably more.
What you want to know is how much “skin in the game” they really have. Some may argue that taking your money in fees and putting it into their investment isn’t putting skin in the game. This is entirely up to you.
Pay close attention to the fees and the amount of “skin in the game” they put into the deal. Oftentimes, it’s a small fraction of the total raise. In the example above, assuming a total raise of $6 million and $400,000 worth of “skin in the game,” this would represent only 6.7%.
In contrast, when we acquired our 160-unit property, the general partners in that deal put in 60% of the total raise.
How much are you making if the property fails to perform?
When you understand how a general partner earns money, you will discover that a portion of their total income from a deal is earned regardless of performance. In other words, the deal could go south and you, along with all of the other passive investors, could lose all of the money you invested.
So you’d want to ask the general partner how much money they’d make if this happened.
In a previous article, we calculated how much money GP makes. Using the data from that article, the GP would still earn $600,000 if the purchase price was $20 million and the annual revenue was $2 million.
Remember that the GP does not have to invest any of their own money to earn this $600,000. They will receive this money regardless. Not a bad payout for failing at their job!
How much are you making if the property sells for the target price?
If someone is selling you a service, don’t you want to know how much it will cost you?
The problem is that the amount GPs make is often hidden and not transparent. This is why we wrote an article about how much GPs make.
I would advocate for the inclusion of a metric in every syndication. So how much a GP is making with your money is completely transparent.
Consider that, in addition to an IRR (internal rate of return) or an equity multiple, a metric shows you how much money the GP makes compared to the passive investor. For example, instead of your 2x equity multiple (you put in $100,000 and get $200,000 back after five years), what if the GP makes 100x the money, time, and effort they put into the deal? Would you find that information helpful?
There’s nothing wrong with a deal sponsor making more; it’s just that we believe it should be transparent. Without transparency, there’s no way to know if a GP is earning significantly more than usual or not – and you deserve to know.
Can I shelter my W2 or 1099 income using bonus depreciation?
General partners in syndications often suggest in their advertising that you can shelter W2 or 1099 income when you invest in a syndication.
The truth is, if you’re a passive investor, you cannot shelter W2 or 1099 income under any circumstance.
In order to shelter this type of active income, you must have a status called Real Estate Professional Status or you need to materially participate in short-term rentals. Only a small percentage of high-income professionals choose to achieve either of these designations.
[Want to learn more about sheltering your hard-earned income with real estate professional status? Be sure to download our free Real Estate Professional Status Guide]
So you really want to look out for their response to this question. If they even suggest that you can shelter your income, proceed with caution. Either they don’t know enough about how these tax shelters work, or they aren’t being honest with you.
Are you claiming bonus depreciation based on the amount of money you are putting into the deal?
This one is a bit obscure and requires some explaining, so hang on.
Bonus depreciation is an expense that often creates large paper losses. As a passive investor, you can use these losses to shelter passive gains. As previously stated, they can’t be used to shelter W2 or 1099 income. If you don’t have passive gains, they become suspended passive losses, and you carry them forward until you have passive gains or the property sells.
Furthermore, when you invest in a syndication, you want the maximum amount of bonus depreciation to have access to the most significant losses. The more losses, the more passive income you can shelter.
Also, the amount you claim is proportional to the amount of money you put into the deal. GPs can also access this bonus depreciation if they put money into the agreement. As above, sometimes this money comes from the fees they receive for putting together the deal.
But the issue is that GPs sometimes claim more than the proportion of money they put in the deal. They do this by structuring the deal in a way that allows them to claim more depreciation. When that happens, they take a bigger portion of the bonus depreciation pie, leaving you with less.
Whether or not this is fair is up to you to decide. But if you never ask this question, you’ll never have the right information to decide for yourself.
It’s important to note that not all GPs do this. Many will give you the share that is exactly proportional to the money you put in. In fact, that’s what we did when we structured our syndication. We had the option of taking a larger proportion of the bonus depreciation, but we specifically chose not to. We wanted to ensure that the passive investors got their fair share.
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Key takeaways
The next time you invest in a syndication, don’t be shy about asking the hard questions. The more informed you are as an investor, the better your decision-making is, and ideally, you make better investments.
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