Private Real Estate Syndications: A Q&A with Kinloch Capital's Peter Walls
Sands Anderson’s Brian Pitney recently interviewed Founding Partner and Chief Investment Officer Peter Walls of Kinloch Capital about private real estate syndications. They discussed how Kinloch Capital identifies commercial real estate opportunities and how they benefit Kinloch’s investors in addition to traditional investments in stocks, bonds, and other private equity.
What type of private real estate syndications do you offer your clients and how do they work?
Walls: Over the past five years, Kinloch Capital has been involved in about a dozen private real estate syndications. Most have been either multifamily or grocery-anchored retail, though we recently completed deals in the medical office and hospitality spaces. Essentially, a syndication is a partnership of investors which allows an individual or family to purchase a real estate asset that would be too large or complex to do on their own. It is a pooling of funds. Let’s say we believe there is a promising investment return to be made on a newly built apartment complex in a fast-growing area of town. A developer might be trying to sell it for $5 million. We’re probably going to need $2 million of equity (i.e. a downpayment) and we’ll borrow $3 million from a lender. That $2 million could be 20 clients kicking in $100,000 each. Each participant then owns a piece of the deal and earns a return on their $100,000 contribution.
How have higher interest rates over the past few years impacted commercial real estate opportunities available to Kinloch investors, and do you see any improvement in the market since the Fed started cutting rates last month?
Walls: Generally, the single largest expense when buying commercial real estate is the debt/loan payment, so rates matter a lot. When rates were low in 2019 – 2021, I was getting numerous calls per month about deal opportunities. Those calls probably fell off by 75% in 2022 - 2023. I’ve seen some uptick in activity recently, but I think rates will have to get back to around 5% before we will see activity levels like before. Fortunately, we’ve been able to get a couple of deals done lately by coming in as cash buyers (meaning we paid all cash and borrowed no money). Rates don’t really matter if you’re not a borrower. While investor rates of return are generally lower on “all cash” deals, not every deal needs to be a grand slam. Given the right opportunity, you can still make solid returns even when paying cash.
Describe your ideal client who invests in real estate syndications?
Walls: Our offerings are filed with the SEC under “Regulation D”. This means participants must be Accredited Investors, which most of Kinloch’s clients are. One can qualify as an Accredited Investor by having a certain income level and/or net worth as defined by the SEC.
Our retired clients like the income that often flows from these deals. Steady and reliable income is the #1 need of retirees. If the investor is lucky, she may be getting 2%-3% dividends on her stock holdings or maybe getting 4% on a CD. But it is not unusual for our investors to receive 5%-10% distributions from their real estate syndications. Putting the percentages into dollars, a client holding $1 million in stocks might be getting $20,000-$30,000/year in dividends. One million invested in a CD could generate perhaps $40,000/year in interest, but a $1 million investment in commercial real estate may distribute $50,000-$100,000 per year. This is up to five times the income for the same amount of dollars invested.
For our clients who are still working, the distributions are secondary to the capital appreciation of the underlying real estate. The fact is, well maintained real estate tends to appreciate over time. Think about what houses in your neighborhood were selling for 10 years ago versus today. It works the same way with apartment complexes and Food Lion shopping centers, but the numbers are much bigger. If a $500,000 house appreciates over time to $750,000, that’s an increase of $250,000 to the owner. But if we buy a $10 million shopping center and it appreciates at the same rate over the same time that’s an increase of $5,000,000. That equity appreciation is split among investors at the time of sale.
What tax advantages do your investors enjoy by investing in real estate opportunities?
Walls: Syndication investors do enjoy tax benefits, particularly on the income received (which we refer to as distributions). Typically, distributions are made quarterly. While the investor gets a quarterly check that can be spent, at the end of the year a Form K-1 is issued which typically shows a loss for tax purposes. We know that in the “real world” real estate tends to appreciate over time, but for accounting and tax purposes, investment real estate actually depreciates over time. It’s the concept that when you install a 20-year roof in 2024, in 2025 that roof is now only has 19 years of life left, so something must have been lost. The same with an HVAC system that’s rated for 10 years - next year it has only nine years of life remaining, so it must be worth less. This is referred to as the “depreciation” of an asset. Going back to our investor that contributed $100,000 to a deal, that person might receive $7,500 in cash distributions this year which could be used to take a vacation, but she will also receive a K-1 tax form showing $10,000 of depreciation. That depreciation offsets the cash distribution, resulting in that income being tax free that year. Investing in real estate through syndications is much more advantageous than how most investors get real estate exposure in their portfolio which is though investing in Real Estate Investment Trusts (REITs). REITs are most often publicly traded stock vehicles which own underlying real estate. However, REIT income is not tax advantaged and is fully taxable at ordinary income rates.
Where do you find real estate opportunities for your clients, and what makes those opportunities different than your clients owning commercial real estate directly on their own?
Walls: It’s been said “it’s not what you know, but who you know”, and this is particularly true in commercial real estate. It’s a people business, and I’ve been networking heavily in Richmond’s investment real estate ecosystem for more than eight years now with commercial real estate brokers, commercial lenders, syndicators, developers, property managers, commercial contractors, real estate attorneys, valuation specialists, and CPAs. It takes a village to put together a deal and manage it successfully. It took a while to become recognized but now Kinloch Capital is becoming a known entity in Richmond’s real estate scene. Early on, I was making a lot of outbound phone calls looking to create opportunities for our clients, but increasingly Kinloch is the one being solicited by well-known Richmond real estate players and being invited to participate in various projects.
The biggest difference between being an investor in a real estate syndication and buying a piece of commercial property on one’s own is twofold. First is the size and quality of the asset that can be purchased in partnership as opposed to on one’s own. Even if an investor has $5 million to invest, it is unlikely that he will put that all into one piece of real estate because that would be risky. However, that investor could take a piece of that $5 million, and in conjunction with others, buy that “trophy asset”, and earn similar returns with less risk. Speaking of risk, a second difference is that when an investor takes a position in a syndication, he becomes a “Limited Partner” (LP) in the deal. That LP status offers protections that are not given to the General Partner (GP) – a.k.a. the syndicator or the person/team putting the deal together. Going back to our scenario where $2 million is being raised to buy a $5 million apartment complex, the $3 million difference is going to be borrowed from a bank and it’s the GP who will have to sign a personal guarantee for that $3 million. LPs don’t sign for the loan because the GP is exclusively responsible for the repayment. While the LPs are apt to enjoy a higher rate of return on the deal because of the loan leverage, they don’t take on the risk of the loan itself.
CONTRIBUTORS
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Peter serves as the Chief Investment Officer at Kinloch Capital. A financial professional for more than 20 years, he has worked on behalf of clients at Prudential Insurance, Wachovia Securities, and Merrill Lynch. He can be reached at peter.walls@kinlochcapital.com. |
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