Behind the Scenes of a Real Estate Syndication
Private Mortgage Lending vs. Syndication Investing [Understanding the Structure, Process, Risk & Potential Reward]
If you’ve followed Houston Capital Group for any length of time, you know that we spend a lot of time talking about private mortgage lending.
The concept is relatively straightforward: a private lender provides capital for a real estate transaction, earns an agreed-upon rate of interest, and the loan is typically secured by real estate.
But what happens when the opportunity becomes larger and more complex?
That’s where a real estate syndication may come into play.
Recently, I’ve been working through the process of putting together a syndication for a commercial real estate project. I recently shared some of that process at The Brkthru, not to promote the investment, but to show people what actually happens behind the scenes before a sponsor ever begins raising capital.
And I thought it would be worthwhile to share some of those lessons here as well.
Important: This article is provided for general educational purposes only. It is not an offer to sell or a solicitation to purchase any security or investment. Any actual offering would be made only through appropriate offering documents and in accordance with applicable securities laws.
Private Mortgage Lending vs. a Syndication
Let’s start with the biggest distinction.
With traditional private mortgage lending, you’re generally acting as a lender.
With a syndication, you’re generally investing equity into an entity that owns or operates an investment.
That creates some major differences.
Private Mortgage Lending
Investor acts as a lender
Predetermined interest rate
Typically secured by a mortgage/deed of trust
Defined loan term
Primary focus is loan + collateral
Upside typically limited to agreed interest
Typically less operational exposure
Real Estate Syndication
Investor typically owns an equity interest
Returns depend on investment performance
Investment is generally ownership in an entity
Often a multi-year investment
Must evaluate the entire business plan
Potential for cash flow + appreciation/profits
Greater exposure to property/business performance
Neither is inherently “better.”
They are simply very different investment structures with different risk-and-reward profiles.
Why Do Real Estate Syndications Exist?
Imagine finding a $1 million, $5 million or even $20 million commercial property.
The opportunity may be attractive, but purchasing it yourself could require an enormous amount of equity.
Instead, a sponsor or General Partner (GP) may put together a group of investors who contribute capital toward the acquisition.
The sponsor is typically responsible for things such as:
- Finding the opportunity
- Negotiating the transaction
- Performing due diligence
- Developing the business plan
- Structuring the financing
- Creating financial projections
- Coordinating legal documents
- Raising the equity
- Managing the investment
- Communicating with investors
- Ultimately executing the exit strategy
The investors, or Limited Partners (LPs), are generally much more passive.
But before any of that happens, there’s one extremely important question.
Is This Actually a Good Deal?
This is where I believe reputable sponsors should spend an enormous amount of their time.
When we first looked at the commercial project we’re currently working through, our first reaction wasn’t:
“How much money can we raise?”
It was:
“Does this deal actually make sense?”
Those are two very different questions.
Due Diligence: Looking for Reasons NOT to Do the Deal
One of the biggest mistakes I’ve seen investors make over the years is falling in love with an opportunity too early.
Once that happens, it’s easy to make the numbers justify what you already want to believe.
I prefer the opposite approach.
Try to kill the deal.
Ask the uncomfortable questions.
For the commercial project we’re currently working on, that means investigating things such as:
- Location
- Traffic
- Parking
- Property condition
- Renovation costs
- Historic restrictions
- Insurance
- Licensing
- Competition
- Operating expenses
- Financing
- Business feasibility
- Market demand
- Exit strategies
And most importantly:
What happens if we're wrong?
That’s a question I believe every sponsor should be asking.
Financial Projections Aren't About Predicting the Future
Any spreadsheet can produce an impressive looking return.
Change a few assumptions and suddenly almost any investment can look fantastic.
That’s why I don’t believe the purpose of financial modeling is to predict exactly what will happen.
It’s about understanding what could happen.
For our current project, I’ve spent considerable time modeling revenues, expenses, payroll, cost of goods sold, financing, taxes, insurance, improvements, reserves and other operating expenses.
Then you start changing assumptions.
What happens if revenue is 20% below projections?
What if renovations cost more?
What if opening is delayed?
What if operating expenses increase?
How much cash should be held in reserve?
Where is the break-even point?
Good underwriting shouldn't just show you how much money you could make.
It should show you how the investment could lose money, and whether you can survive that scenario.
Risk vs. Reward
This is another significant difference between mortgage lending and syndication investing.
With a typical private loan, the lender may agree to earn a predetermined interest rate. If the borrower performs according to the loan documents, the lender knows what they’re supposed to receive.
A syndication is different.
Because investors typically participate in the economics of the investment, there may be the potential for considerably greater returns through:
- Operating cash flow
- Property appreciation
- Forced appreciation
- Business growth
- Refinancing
- Sale proceeds
But here’s the part nobody should gloss over:
Greater potential reward usually comes with greater risk.
Projected returns aren’t guaranteed.
Values can fall. Costs can increase. Businesses can underperform. Construction can run over budget. Financing markets can change. An investment may take longer than expected to exit, and investors can lose some or all of their investment.
That’s why I think it’s a mistake to evaluate a syndication based solely on its projected return.
You also have to evaluate the assumptions, risk, structure, sponsor and plan.
You're Investing in the Operator Too
This may be one of the most overlooked components of syndication investing.
A great property with a bad operator can become a bad investment.
When evaluating a sponsor or General Partner, I believe investors should consider questions like:
- What’s their track record?
- How much experience do they have?
- Are their projections realistic?
- How thoroughly did they underwrite the opportunity?
- What risks have they identified?
- What reserves are being maintained?
- What happens if the original plan fails?
- How frequently will investors receive reporting?
- How transparent is the sponsor when something goes wrong?
- Does the team have the experience necessary to execute the business plan?
I believe credibility is built over time through results, transparency and communication, not through a pitch deck.
Raising Capital Comes Last
This is probably my biggest takeaway from putting our current project together.
Before raising a dollar, there’s a tremendous amount of work to do.
The sequence should look something like:
Opportunity → Due Diligence → Business Plan → Underwriting → Risk Analysis → Financing → Legal Structure → Investor Materials → Capital Raise
Not the other way around.
By the time a potential investor ever sees an investment summary or presentation, a responsible sponsor may already have hundreds of hours invested in understanding the opportunity.
The deal isn’t what matters most. The process is.
A Quick Word About Securities Laws
Real estate syndications generally involve securities, which means sponsors must work with qualified securities counsel to determine the appropriate structure and exemption.
Two commonly discussed exemptions are Regulation D Rule 506(b) and Rule 506(c).
Broadly speaking, Rule 506(b) prohibits general solicitation and permits sales to accredited investors as well as up to 35 sophisticated non-accredited investors, subject to additional requirements. Rule 506(c) allows general solicitation, but all purchasers must be accredited investors and the issuer must take reasonable steps to verify that status. You can read the SEC’s explanations of Rule 506(b) and Rule 506(c).
That’s another reason putting together a syndication is very different from simply finding a deal and asking people to invest.
Final Thoughts
I’ve spent nearly two decades working with private capital, and one thing hasn’t changed:
Trust matters.
Whether someone is making a private mortgage loan or participating in a larger real estate syndication, the fundamentals remain remarkably similar.
Understand the opportunity.
Understand the people.
Understand how your capital is being used.
Understand the downside—not just the upside.
And never invest simply because the projected return looks attractive.
For me, working through our current commercial syndication has been another reminder that good investments are built long before closing.
Good operators spend more time planning than pitching.
About Houston Capital Group
Houston Capital Group exists to educate individuals about private lending, real estate investing and alternative ways investors may participate in real estate.
Want to continue learning about how private capital and real estate investments are structured? Contact Houston Capital Group to connect with our team and learn more about what we do.
This material is for educational and informational purposes only and does not constitute an offer, solicitation, investment advice, legal advice, or tax advice. All investments involve risk, including the potential loss of principal.