Brian Nelson: The Pros and Cons of Real Estate Syndication

Since the Great Recession of 2008, we’ve seen numerous properties offered in the securitized real estate syndication industry, especially when it comes to the TIC and the 1031 space. From my vantage point as a 1031 sponsor, the landscape has changed dramatically. While some of the larger players have left the industry, others have taken advantage by accelerating growth, filling the void and expanding their presence. 

What hasn’t changed much, though, are the core objectives of the end-user investors. Capital preservation and stability are more important than ever. In the post-Madoff era, trust is a premium that is hard to earn, as is income. Investors want cash flow and tax benefits, and they have a difficult time finding them with traditional vehicles.

This component is steadily bringing in new investors who are learning that passive real estate can provide a wide array of benefits. But as it becomes increasingly easier for a client to invest in real estate, it has not been so easy for real estate sponsors. Barriers to entry are high. Due diligence officers, RIAs, savvy investors and registered representatives want to see track records, strong balance sheets, healthy cash flow and a proven back office. 

As more and more international funds and larger private equity firms drive up prices for prized real estate, the buying competition can be fierce — and that’s not even mentioning the lenders. 

With student housing in particular, more and more groups are viewing it as a compelling asset class worthy of an increasing allocation of their portfolio. Roughly speaking, the volume of student housing transactions have more than tripled in the last five years. 

Another intriguing component of the syndications of the model is the regulations. Typically, most syndication is through securities channels regulated by FINRA and the SEC, both of which have been establishing rules and notices specifically tailored to the syndication model. While these regulators provide benefits and protections to investors, it’s one more nuance for new entrants to learn and to work with. 

When the tenant-in-common model was a popular strategy for 1031 exchanges, it seemed that there was always a question hovering: Is it real estate or a security? Once the mortgage industry collapsed, the lenders scattered, TICs proved to be a risky investment, there was even greater regulation than ever before. 

As a real estate sponsor offering investments as a security, there are numerous regulations and rules that we abide by as set forth by FINRA and the SEC, especially with the marketing and advertising guidelines and the pre-existing relationships we have with our investors. These are all monitored by our broker/dealer, and auditors from FINRA will come out and visit the offices on an intermittent basis to ensure that firms such as ours are abiding by the regulatory requirements. 

So if there are so many rules and regulations that a securitized real estate sponsor needs to follow, what are the potential benefits of all the work involved with creating this type of a structure for the investor? There are several answers for that:

  1. We make most of our fees up front. Of course, it’s important to be reasonable with the charges, and with increased competition, fee structures have decreased substantially over the last five years. Transparency dictates that through the Private Placement Memorandum (PPM), investors will need to acknowledge receiving and understanding the risks and information disclosed therein when signing the purchaser questionnaire and purchase agreement. 
  2. The infrastructure is fairly easy once all the processes are in place. There’s a streamlined process with organizing all the paperwork, filling out the documents, working with the lenders and communicating with investors. Projects in our industry can have a broad range of investors. We’ve seen one-off projects with a sole investor, projects with a small group of investors, and others that extend to more than 400 investors. It’s a broad spectrum. That can be challenging initially, but once a sponsor finds the right rhythm of communication, processes and responsiveness, it can become a competitive advantage. 
  3. Investors generally must at least be accredited. Most are financially savvy and work with an experienced broker. They’ll do their homework — i.e., review a variety of sponsors, products and real estate categories and carefully make decisions. While this process requires patience, repetition and constant rejections, once an investor starts working with you, you have the ability to turn them into a lifetime client — one of the advantages of longer-term investments. Over time, this can help create a strong, loyal base. Frequent interaction with a large base can help sponsors stay in touch with investors’ objectives, fears, preferences, etc., and allow a sponsor to be more nimble than larger firms. 

We often get asked about our thoughts on the TIC debacle from the last recession. It’s a natural question. And every real estate sponsor, broker and investor should use history as a learning tool. In my opinion, one of the greatest challenges of the TICs was that many offered real estate investments that were not designed adequately for mom and pop investors. Imagine a big-box retail center or a large office building. Some of those assets that are closely tied to the economy were hit dead on. 

When assets like this lost tenants, it would have a direct-to-cash flow impact. The lenders would start to panic, and investors were required to come to a consensus on such decisions as, “Should we each add new capital for leasing commissions and tenant improvements to add a new tenant willing to sign today at a substantially lower price per square foot?” The decision-making process was cumbersome and drove lenders crazy. 

But for properties such as multifamily, self-storage, and, in my case, student housing, these issues were a lot easier to work through. Frankly, these latter assets just don’t appear to have been as vulnerable to the cycle. That’s why we like student housing so fondly. Over the last 40 years, there has been almost no correlation between U.S. college enrollment and market or economic cycles. 

Lenders and sponsors took notice and pivoted. The TIC structure was ditched (with a few exceptions) for the simpler Delaware Statutory Trust concept, a 1031-friendly structure that allows more investors/smaller minimum investments, less paperwork, nonrecourse loans with no lender approval requirements for investors, and generally more favorable debt terms. The tradeoff is that lenders want a singular decision-making process. So for a DST, the sponsor is typically the trustee and can make decisions without requiring unanimity from investors.

The DST has emerged as a burgeoning investment structure with tens of billions of assets throughout the US. But the DST has its drawbacks. There are certain rules and regulations that must be met called “The Seven Deadly Sins.”  

As sponsors have become more conversant with the advantages and the limitations of the DST, we have discovered certain asset types tend to be a much better fit for this structure. As a result, long-term NNN lease properties, Class A multifamily, student housing, assisted living, and self-storage have all grown in popularity through the DST. 

Overall, investors should feel comfortable and secure in knowing that their financial portfolio is managed in the best and most prudent way possible. As someone who has seen the ups and downs of this industry, I’m pleased to know that our company can take pride in routinely taking actions that we believe to be the right thing with every step of the investment process and striving to help the investors sleep well at night (SWAN), which is the reason we’re in this business now and (hopefully) for years to come.

— Brian Nelson founded NB Private Capital, a student housing investment company that focuses on securing properties that have stable occupancy near the historical dependability of a university, in April 2018. The goal of NB Private Capital is to leverage Brian’s extensive experience in student housing to create a more investor-centric firm that places greater emphasis on property performance, investor communication, and long-term relationships.

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