Investors ready to dive into the world of real estate investing have more options at their fingertips than ever before, and two of the most popular are real estate syndications vs real estate investment trusts (REITs). It can be hard to choose which route to pursue when getting started, so we break down the highs and lows of each investment type.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More.
Real Estate Syndications Balance Convenience and Potential Returns
Real estate syndications are the best investment option for most people looking to add real estate to their portfolios without the effort of direct ownership. Syndications are groups that take on equity investors for real estate projects, and those equity investors—called limited partners—earn a portion of a profit from the project.
Syndications give limited partners access to large-scale real estate investments that few individuals can afford on their own, so they open an entirely new world of investment options.
Invest in Real Estate Without the Burden
At the helm of a syndication is the project runner, called the sponsor or general partner. The sponsor finds the perfect property, secures financing, completes the purchase, oversees property operations, arranges any renovations, and finally sells the property. That all translates into an intense amount of work, so some syndications have more than one general partner.
Syndication sponsors are usually experts in their field, familiar with the local market and the strategies and economics behind creating maximum profit in a real estate project. When recruiting new investors, sponsors present their past project successes as their résumé to demonstrate their hands-on knowledge.
Because the sponsors manage all these tasks related to the time-intensive elements of running an income-producing property, investors can turn their attention elsewhere, whether that be day jobs, other investment opportunities, or a leisurely retirement.
Syndications are not only a good fit for newer investors who benefit from the expertise of a sponsor, but also for experienced investors who want to branch out from their own local markets into unfamiliar territory or into larger properties with greater cash flow than the average individual can afford.
Expect Returns That Reflect the Time Opportunity of Your Investment
Investors value real estate for its ability to hedge against inflation, meaning that you still come out ahead even when the ever-decreasing amount of a dollar is considered. Unfortunately, most real estate investment opportunities fail to pass this benefit along to investors.
Syndications require hefty capital contributions – usually, at least $50,000, but $100,00 minimum investments are more common. Those funds may be tied up for a few years until the property is refinanced or produces enough revenue to repay investors.
In return for that level of commitment, syndications often offer returns of around 20 annually percent, but keep in mind that each project comes with its own estimates and resulting returns. The more successful the project, the more money everyone makes, including the limited partners.
Unlike in other investment vehicles where profits are swept away and re-categorized to avoid paying dividends, syndication limited partners receive payouts directly tied to the property’s performance. In addition, syndications most often work with multifamily housing properties, so they receive a steady income for tenant rents.
Certain classes of multifamily properties are ripe for renovation, and consequently, rent and value increases. Investors directly benefit from both regular income and profit realized at the sale of the asset.,
Syndications Provide Transparent Payout Structures
Before contributing any capital, sponsors present potential investors with several documents related to the project. They describe the project and plan to create profit, delineate the responsibilities of everyone involved, and also set forth the structure in which everyone gets paid.
The private placement memorandum (PPM) describes the division of profits and is unique to that project. One of the most common payout plans features stepped tiers of payment splits. Accordingly, it is called a waterfall.
Under waterfall methods, general and limited partners split profits at a predetermined rate.
Syndications often include a payment feature called a preferred return that designates that all profits up to a certain percentage, often 7 percent, go to the limited partners. The general partner receives no money until the preferred return is met.
After the preferred return, syndications often favor the limited partners, so the limited partners may receive a 70/30 share of profits.
Then, that ratio can shift as the project makes more money. Upon reaching a specific rate of return or other benchmarks, the split can change, perhaps to 50/50. The process repeats as determined by the syndication documents.
Make Money and Pay Less in Taxes
One of the best parts of investing in a syndication is that equity investors get a proportional share of the project’s tax credits and deductions. But, even better, your share is clearly passed on to you through a Schedule K-1 each year.
The U.S. tax code is generally very favorable to real estate, but many investment types only share the wealth with investors through vague increases in profit that may or may not be at all related to tax breaks.
Syndication limited partners get their own tax documents detailing their share of deductions that the investor then gets to apply to their own taxes. Often, the first year’s deductions completely cancel out the income from the preferred return, meaning investors may owe zero taxes on income earned from the syndication that year. It is not uncommon for the investor to not owe any taxes on their gains until the property is sold.
The business model of syndications makes them particularly rich in tax breaks. Accelerated depreciation and the mortgage interest deduction create major tax deductions in the early years of owning real estate. Given that syndications try to turn over properties within a few years, these tax features make syndication returns even more valuable to investors; they actually get to keep more of the money they earned through the syndication than they would in other real estate investments.
Investors Are More than a Number
The U.S. Securities and Exchange Commission’s (SEC) restrictions on non-accredited investors create the most significant downside of real estate syndications: they can be challenging to find.
The SEC prevents syndications that accept non-accredited investors from publicly soliciting investors, making it hard for investors to find open projects. However, this inconvenience fosters an environment where limited partners are more than just an indeterminate entry in a shareholder database.
Syndications usually rely on a small pool of limited partners rather than a sea of shareholders. And, after funding, sponsors keep investors informed through regular updates about the project and its progress. Many sponsors use an online portal so that investors can easily and quickly access documents, reports, and announcements.
Syndication sponsors expect – and want – to be contacted by potential investors. For example, it is easy to find out about my open projects and invest with me by joining my investor list.
Forums like BiggerPockets and local networking groups are also great ways for non-accredited investors to find projects.
REITs Offer Low Entry-Level but Limited Returns
REITs are another real estate product that catches investors’ eyes when looking for ways to enter the real estate market without taking on the hassle of becoming a landlord. Unfortunately, they lack many features that make syndications such great opportunities for passive investors.
The most winning feature is that they do have a much lower cost of entry – just the price of a single share.
REITs are companies that own and operate income-producing properties, and they can be found for all types of properties. For example, REITs may specialize in hotels and tourism, medical offices, multifamily housing, and more. The REITs that own real estate are called equity REITs while mortgage REITs hold debt rather than property.
Investors buy shares of the REIT, and they trade on exchanges just like ordinary stocks. However, the major draw of REITs is that they pay a higher rate of dividends than the average stocks. While the average stock dividend yield is 1.9 percent, equity REITs pay, on average, just under 5 percent, and mortgage REITs average about 10 percent.
REITs Must Pay Dividends to Retain Status, But Loopholes Exist
REIT dividend rates are usually higher than other stocks because they must pay 90 percent of taxable income out as dividends to maintain REIT status. But, unfortunately, this does not make REITs an automatic cash cow for investors.
Taxable income rarely represents the actual value of a real estate investment, which holds true for REITs. Just like syndications, REITs get to claim a massive amount of depreciation at tax time. However, while syndications pass on that benefit to investors to save the investors money, REITs hold on to those deductions themselves to reduce their taxable income and pay investors less.
When the REIT takes the tax advantage at the corporate level, it results in investors’ earnings being taxed at the ordinary rate rather than the more advantageous capital gains rate or even the qualified dividends rate.
REIT Structure Limits Growth Potential
REITs are known for their high dividends, but that defining feature inherently limits stock appreciation. This hamstrings investors who want to add real estate to portfolios to benefit from appreciation in the real estate market and hedge against inflation.
By paying out at least 90 percent of taxable income, REITs have little opportunity to add additional assets. As a result, shares may grow in value very little over time.
Final Thoughts
Investors can take advantage of REITs’ low cost of entry to diversify their portfolios or start investing careers. Still, I recommend syndications take full advantage of the real estate market and make the most of the money you have to invest. So when choosing real estate syndications vs REITs, syndications win.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More.
