What To Know BEFORE Investing in Real Estate Syndications

I’ve been investing in real estate syndications for close to 10 years now, and I’ve learned quite a few things along the way that I wish I would have known before getting started.

Investing as a limited partner in real estate deals is a great way to get exposure to this asset class, participate in some of the best tax benefits available to investors, and access all of this upside within a real estate investment vehicle that’s actually a passive investment.

However, there are some major pitfalls and potential downsides to consider before getting involved with these types of deals. And to share some of the lessons I’ve learned throughout this process, this article covers some of the biggest pros and cons of going this route, and some things you may want to factor in before getting started.

If video is more your thing, you can watch the video version of this article here:

The Pros

Tax Treatment

To start with the pros here, one of the biggest benefits of going this route is the tax treatment associated with direct commercial real estate ownership.

Generally, by investing in a syndication, investors will be considered a member of an entity that owns a commercial property and will participate in the tax status that comes along with direct ownership.

The Tax Cuts and Jobs Act also introduced bonus depreciation for real estate owners, which allowed investors to depreciate up to 100% of the components of a property with a 5, 7, or 15-year useful life in their first year of ownership. And even though this began to be phased out in 20% increments starting in 2023, depreciation is still a huge benefit for direct investors to reduce the tax burden associated with real estate investment income.

Depending on the value allocation between the land and the building being acquired, this “paper loss” in the first year of ownership can end up being substantial, often far in excess of the property’s taxable income before depreciation is deducted. In many cases, this can result in distributions from operating cash flow being completely tax-free, and significant carryover losses that can be used to offset future income.

Choosing Your Investments

In addition to the tax benefits of investing in syndications, one of the biggest benefits of investing directly in individual deals versus investing in REIT stock (or a discretionary fund) is the ability to invest only in the deals that you believe in most.

By buying ownership interest in a publicly-traded REIT, an investor is buying a piece of an entire operating company, which can be great if the main goal is diversification across multiple properties.

However, by doing this, that investor is also saying “yes” to all properties the company holds within their portfolio, regardless of whether they believe in the upside of each individual asset.

But by investing directly in syndications, investors are able to confine their investments only to the specific product types and geographic markets they believe in most, and even the specific business plans they feel most comfortable with.

This ends up being a huge benefit for investors that have a strong belief or conviction about where the market is headed and want to take big bets to maximize their potential upside, and also allows investors to avoid sectors of the industry that they believe might be in decline.

A True “Passive” Real Estate Investment

One of the biggest benefits of investing in syndications is that, unlike other forms of direct real estate ownership, these are actually a passive investments.

Even though limited partner investors will be partial owners of a company holding a piece of real estate, they won’t be the ones responsible for acquiring, managing, or selling deals.

Especially if you already have a career you enjoy and don’t have the time or desire to spend nights and weekends talking to brokers and touring properties, going the passive investing route can be a much more enjoyable way to build a real estate portfolio.

By investing alongside a group of partners, investors also get the added benefit of being able to invest in larger, institutionally-managed deals, which can often significantly reduce the risk associated with an investment and maximize the buyer pool in a variety of market conditions.

The Cons

Fees & Promoted Interest

The first thing to note related to the cons of passive real estate investing is that passive, limited partners pay fees and promoted interest that can create a drag on returns.

Passive investors pay fees at almost every part of the investment cycle, whether that’s an acquisition fee when the property is initially purchased, an asset management fee throughout the ownership period, a construction management fee during a renovation, or a disposition fee at the time the property is sold.

Investors in syndications also typically give up a significant portion of their profits in cases where the sponsor exceeds a predetermined preferred rate of return, which can also materially impact LP distributions when it’s time to exit the deal.

Between all fees and promoted interest paid to the sponsor (the active partner that’s operating the property), with a project-level IRR in the ~15%-19% range, the drag on LP returns can often be anywhere from about 2% to 5% (depending on deal structure).

This means that, if the investment generates a 17% IRR at the project-level, the limited partners on the deal will usually see a 2%-5% reduction in that figure, resulting in a ~12%-15% IRR on their equity investment in the deal.

However, while this is a material drop-off from project-level returns, when comparing these to other passive investment vehicles with similar risk profiles (and often less favorable tax treatment), a 12% to 15% percent annualized return is still very attractive for many passive investors.

And even though it doesn’t necessarily feel good to give up a few percentage points to the active partner on a deal, when considering the lack of required involvement overall and comparing this performance to other investment vehicles available in the market, this drag can start to feel a lot less relevant to limited partner investors.

Lack of Control

Another notable downside of going this route is the lack of control that limited partner investors have over their syndication investments.

As a limited partner, investors don’t have control over the amount or timing of operating cash flow distributions they’ll receive, investors don’t have a say in refinancing decisions when an acquisition loan matures, and investors also don’t have control over the timing of a sale.

This can be a problem if an investor is relying on their real estate portfolio to fund their lifestyle or retirement, since distributions can quickly change based on market conditions, and this can also be a problem when it comes to tax optimization.

For investors with unique tax situations that want to have full control over their investments (and when they choose to sell), LP investing may not be the best fit.

K-1 Filings

The last con I want to mention in this article can become a significant issue as an investor’s portfolio starts to grow, and this is that the timing and costs associated filing taxes for these investments can often be significant.

By investing directly in a partnership, investors will generally receive a Form K-1 at the end of the year for each deal they invest in, and this is going to be required to file their tax returns.

However, the timing of actually receiving these K-1s can vary a lot from partnership to partnership, and since business taxes generally aren’t even filed until the middle of March each year, this often results in investors having to file an extension when it comes to their personal tax return.

Some tax professionals will also calculate tax prep fees based on the number of K-1s each client needs to file, which can make these costs sometimes even greater than the distributions investors will receive from smaller equity investments.

Taxes can also start to get really tricky when investing in properties located in different states, often requiring the filing of multiple state tax returns, which can also increase tax prep costs and increase the complexity of an investor’s personal tax return.

How To Learn More About Real Estate Investment Analysis

If you want to learn more about how to analyze real estate investment opportunities, whether you’re a passive investor or an active investor putting together your own syndications, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam. This exam covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.

As always, thanks so much for reading, and make sure to check out the Break Into CRE YouTube channel for more content that can help you take the next step in your real estate career.