Making the Grade: Evaluating Viability in CRE Syndications with 10% Returns

21st November 2024 | by the Investment Grade Team

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The Question of “Skinny” Returns in CRE Syndications

Commercial real estate (CRE) syndication can be highly lucrative, but when you’re analyzing deals to synidcate with a projected 10% annualized return, you might wonder if it’s “too skinny” to pursue. For many seasoned investors, a 10% return may fall short of what is expected, especially when considering the inherent risks of real estate investments. To attract investors, a project must balance returns with perceived risks and create enough profit margin for the syndication team to justify their efforts.

This article will explore why a 10% return is often seen as insufficient, how leverage can enhance potential profitability, and what key factors syndicators need to consider to ensure their deal “makes the grade” for both investors and the syndication team.

Assessing Viability: Why Cash-on-Cash Alone May Not Cut It

One common misconception is that a cash-on-cash return of 10% automatically makes a deal viable. However, cash-on-cash return alone does not capture the full picture of an investment’s potential. While it is an important metric that measures the income produced relative to the cash invested, it fails to account for the entire profit that may be realized upon the sale of the property.

In most successful CRE syndications, investors look for a combination of strong cash flow during the holding period and substantial gains upon the exit. They want a compelling internal rate of return (IRR), which considers the timing of cash flows over the life of the investment, typically aiming for IRRs in the 12-18% range. Investors also consider equity multiple—the ratio of the total cash received to the total cash invested—as a metric for assessing the overall profitability.

Additionally, investors weigh the risk associated with the deal. For a property perceived as high-risk, such as a value-add or development project in an emerging market, a 10% cash-on-cash return may be unattractive without the prospect of significantly higher upside. Investors in these types of properties generally want annualized returns in the mid-teens or higher, in line with the risk profile they are taking on.

The Leverage Play: Increasing Returns through Debt Financing

If you’re seeing returns around 10%, it’s possible that you’re assessing the deal as an all-cash transaction. All-cash deals can be beneficial for reducing risk and simplifying management, but they typically result in lower returns due to the lack of leverage. In the world of commercial real estate, utilizing debt is a key strategy to enhance returns. This leverage effect allows syndicators to finance a portion of the purchase at an interest rate that is often significantly lower than the returns investors expect from equity.

Debt financing essentially means using a lender as your least expensive “investor.” Banks or other financial institutions provide loans with an interest rate—which might range from 5% to 7% for many types of commercial properties—and this cost is much lower compared to the 12-18% return that equity investors typically want. By leveraging debt, you effectively increase the return on the equity invested, as the capital from the loan is amplifying the income and capital appreciation from the property.

For example, consider a property purchased at $5 million, where $3 million is financed through debt and $2 million is equity. If the property’s value grows and generates substantial income, the return on the $2 million in equity will be higher than if you had purchased the property outright without leverage. Thus, strategic use of leverage allows syndicators to offer competitive returns to investors while still retaining a share of the profits for themselves.

The concept of the loan-to-value (LTV) ratio also plays an important role here. Syndicators should aim for an optimal LTV that balances risk and return. Typically, an LTV of 60-75% is common for many CRE deals, allowing for sufficient leverage to boost returns while maintaining enough equity to cushion against market downturns and unexpected changes.

When 10% Might Be Acceptable (And When It’s Not)

There are circumstances when a 10% return might be acceptable to investors, particularly if the asset is considered low-risk. For example, a triple-net lease (NNN) property with a long-term, creditworthy tenant could provide stability that offsets the relatively lower return. These types of properties are attractive to investors who prioritize stability and predictability over higher risk-adjusted returns.

However, the risk-return tradeoff is fundamental in real estate investing. Investors seeking exposure to properties with a higher risk profile—such as value-add multifamily, hospitality, or new developments—expect returns that adequately compensate them for the increased uncertainty. For these types of assets, a projected return of 10% would likely be viewed as insufficient because it does not offer an appropriate premium above more stable, core real estate investments.

Risk perception also depends on market conditions. In a rising interest rate environment or a volatile economy, investors demand higher returns to compensate for macroeconomic risks. Consequently, when analyzing deals, it’s critical for syndicators to consider the asset type, location, market cycle, and economic conditions that influence investors’ required returns.

Building a Profit Margin for Syndicators: Why You Need 25% or More

One of the most important considerations for a syndicator is whether the deal provides enough upside for their own compensation. If your analysis shows that you cannot retain at least 25% of the profits for yourself or your team within a few years of acquisition, then you might be undertaking substantial work for minimal rewards. It’s essential to structure the deal to ensure syndicators are compensated adequately for the risk and effort involved.

Most syndications are structured to include a preferred return and a profit split. Preferred returns—commonly around 7-8%—mean that investors receive the first claim on profits up to that percentage before any profit-sharing with the syndicator takes place. After the preferred return is met, any remaining profits are typically split, often in an 80/20 or 70/30 fashion between investors and the syndication team.

To illustrate, imagine a syndication with a preferred return of 8% and a 70/30 profit split. If the property produces sufficient cash flow, investors receive their preferred 8% return, and any additional profits are shared—70% to investors and 30% to the syndicator. This kind of structure ensures that investors are taken care of first, but also that the syndicator receives a significant share once the investment performs well. This incentivizes syndicators to maximize property performance while ensuring there is enough upside to make their involvement worthwhile.

Ultimately, if the deal doesn’t provide enough return for both investors and syndicators, it’s not a viable investment. Syndicators must carefully structure deals to ensure there is ample “promote” to compensate for their expertise, time, and risk exposure.

Increasing Investor Appeal and Justifying Sponsor Fees

If a deal with a projected 10% return still feels borderline, there are ways to make it more attractive to investors. For one, adding value-add elements can significantly increase future cash flows, allowing for higher overall returns. For example, property renovations, operational efficiencies, or implementing better management practices can drive up rents, decrease expenses, and increase net operating income (NOI), ultimately improving investor returns.

Another strategy is to consider extending the hold period of the investment. While shorter-term investments often appeal to those who want a quicker return of capital, extending the timeline may allow for greater appreciation and cash flow growth, which can boost overall returns. An extended hold might help achieve a balance between cash flow during the holding period and a strong exit price, resulting in a better total return.

Additionally, syndicators should focus on how they communicate the deal’s potential. Highlighting additional sources of value creation, such as tax benefits from depreciation, potential upside from market growth, or non-traditional revenue streams like adding paid amenities, can help justify a sponsor’s fees and the proposed return profile. Clear, transparent communication with investors helps build trust and aligns expectations, making deals more appealing.

Ensuring Your Deal “Makes the Grade”

In summary, a 10% annualized return often falls short for CRE syndications because it may not adequately compensate investors for the risk they undertake, nor does it provide sufficient upside for syndicators. To make the grade, syndicators must leverage debt effectively, consider the risk-return tradeoff, and structure deals to ensure they capture a reasonable share of profits.

By optimizing deal structures, using leverage, adding value, and communicating effectively, syndicators can craft a viable investment that attracts investor interest and ensures the hard work involved is ultimately worthwhile. Ensuring that both investors and syndicators are adequately rewarded is the key to long-term success in the world of CRE syndications.

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