SMB Investing for Real Estate Investors

Real estate assets and business operations often go hand in hand—you may invest in or buy a business that owns the associated real estate and vice versa; investing in real estate requires someone to manage the properties as a business. This interconnected relationship leads many real estate investors to be well-versed and experienced in running and operating businesses. 

As an asset class, real estate and small to medium-sized businesses (SMB) share many similarities, such as legal structure, distribution waterfalls, and the GP/LP relationship. As a result, real estate investors may find SMBs as an attractive diversification opportunity to gain exposure to other cash-flowing investments. 

Below, we’ll discuss some key similarities and differences between real estate investing and SMB investing.

Before we get started, there are many ways to invest in real estate: publicly traded REITs, buying rental properties, and real estate syndications. This article will compare passively investing in real estate syndications to passively investing in small business acquisitions.

Ownership structure of SMB acquisitions

Real estate syndications are typically set up as either a limited liability company (LLC) or a limited partnership (LP), and the sponsor either serves as the manager of the LLC or the General Partner of the LP. In either case, the real estate sponsor will raise capital, manage the investment, and make strategic decisions, while investors take a passive role and contribute capital to the investment opportunity. 

This ownership structure is similar to SMB acquisitions. Investors who purchase a stake in an SMB acquisition typically invest in an SPV entity—which is organized as an LLC or C corporation structure. The SPV will then purchase the existing stock if the acquisition is a stock sale or simply manage the operating assets if the transaction is an asset sale.

How do fees differ between SMB acquisitions and real estate syndications?

SMB acquisitions typically have a much lower fee structure than real estate syndications.

Real estate syndications have several fees involved depending on the type of transaction, which can include:

• Asset management fees: 1-2% of either gross property revenue or net operating income

• Property management fees: 3-6% of gross property income

• Development fees: 3%+ of the capital expenditure budget

• Acquisition fees: 1-2.5% of the acquisition cost

• Disposition fees: 1-2% of the sale price

• Financing fees: 0.5-5% of the loan amount

• Carried interest/promote: Can range from 20-40% of profits after certain IRR hurdles have been met

Each deal is different, and you should read the fine print to learn which fees you’re being charged. 

On the other hand, SMB acquisitions—the ones that we most commonly see—can be categorized into two groups: independent sponsors and self-funded searchers.

In self-funded search deals, the searcher doesn’t take a fee but will typically pay for transaction expenses with the business’s cash flow and then will own most of the common equity. Their majority ownership, or implied “carry,” can be thought of as their upside for (1) personally guaranteeing the SBA debt on the deal and (2) assuming the full-time operator role to run the company. 

Independent sponsor deals are put together by a financial sponsor and treated more as a private equity transaction. Independent sponsors typically charge three types of fees: 

• Acquisition fee: 2-5% of the deal size:

• Management fee: 3-7% of EBITDA 

• Carried interest: Can range from 15-25% on the business’s profits and is usually triggered after an investor hurdle rate has been reached 

Investor rights in SMB acquisitions 

Investor rights can be broadly categorized into (1) voting rights and (2) information rights. 

Real estate syndication investors have limited voting rights; however, they typically have the right to receive periodic updates on the financial performance of the property and the syndication. Investor rights are outlined in the SPV’s Operating Agreement. 

Transaction documents in SMB acquisitions are written for the owner to operate the business without too many restrictions and cases that need investor approval. However, investors have information rights based on the deal terms—typically quarterly.

Investing risks in SMB acquisitions and real estate syndications

Investing in SMB acquisitions and real estate syndications has its own unique risks.

Real estate is often seen as a more stable asset class due to its tangible nature and historical resilience. However, real estate syndications face market risks, such as fluctuations in property values due to economic conditions, interest rates, and local market trends. 

Real estate investors are exposed to operational risks like poor property management, unexpected maintenance costs, or prolonged vacancies. Investors also accept liquidity risks and regulatory risks, such as changes in zoning laws or tax policies, which can affect property values and profitability.

SMB acquisitions, on the other hand, have their fair share of investor risks as well. 

One key risk is the searcher's or management team's operational abilities to run the business effectively through adversity like competition and market conditions. These risks can be exacerbated for businesses in more volatile or cyclical markets. 

Investors in SMB acquisitions also face liquidity, legal, and regulatory risks—many of which are found in both real estate opportunities and small businesses. 

Return profile of SMB acquisitions and real estate syndications

Both asset classes follow a waterfall distribution process. 

Real estate syndications invest in a wide variety of assets, ranging from multi-family buildings, single-family homes, commercial buildings, and rentals. While each waterfall process can range substantially, waterfalls typically follow the below process:

1. Return of capital: 100% of cash flow is returned to investors 

2. Preferred return: Also referred to as a “hurdle rate,” all cash flow is returned to investors until they achieve a preferred return on their initial investment, often between 6% and 10% but sometimes higher. 

3. Catch-up: All cash flow goes to the GP until they receive their pre-determined percentage of profits.

4. Carried interest/promote: The sponsor or GP receives a disproportionally larger share of the profits, typically once certain return thresholds are passed.

SMB acquisitions also implement a waterfall return, often a preferred participating structure that pays a preferred return between 8% and 12% on an investor’s initial investment that hasn’t been returned yet. Once investors receive their capital paid back, they are entitled to their share of the business's profits through common equity distributions. Finally, investors are entitled to their portion of the net sale proceeds once the business is exited, which can be a significant increase in value based on market conditions and EBITDA expansion. 

Returns for real estate syndications can range; however, investors can expect anywhere from 5%-15% IRR and a 1.2-2x MOIC for low to moderate risk syndications (core and core-plus assets) to 15-25% IRR and 1.5x to 3x MOIC for higher risk syndications (value-add and opportunistic investments). Returns on SMB acquisitions can vary as well, but often target a 25-35% IRR and 3-4x MOIC on a 5-year exit. 

While SMBs can pose greater operational risks than real estate syndications, investing in this asset class can also generate greater returns on average than real estate syndications.

A comparison of holding time horizons 

Real estate investors can expect to hold their positions for 5-7 years on average but upwards of 10+ years for certain core properties. Real estate syndications are not liquid securities as there is no market that shares trade on—this differs from publicly-traded REIT opportunities that trade on an exchange. 

SMB acquisitions have a similar holding time horizon of 5-7 years before the business is exited or the owner or management buys back shares. 

Whether it’s real estate or SMBs, investing in the private markets is an illiquid type of investment that is dependent on fully exiting the asset or in the circumstance that the sponsor of the deal purchases investor shares back—which will be outlined in the transaction documents. 

Exit opportunities for SMB investors 

Real estate investors may have the opportunity to exit in a direct sale, refinance, or a buyout from the sponsor. 

The most common exit opportunities for SMB investors occur when the business is sold to a strategic or financial buyer. This could be an investment fund, company, or individual purchasing the business for financial reasons or a competitive or synergistic company wanting to add its operations to its existing company. 

Based on the terms of the acquisitions, investors would be entitled to their pro-rata share of the net transaction proceeds. 

It’s also possible that the operator would recapitalize the company, therefore cashing out existing investors or purchasing investor shares back after a pre-determined time or return hurdle, allowing investors to walk away with their pro-rata share of the value of their membership interests.

Each SMB acquisition is different, and it’s important to review the financial models to understand how the sponsor of the deal anticipated investor distributions and exit scenarios.   

Why we think investing in SMBs is an attractive opportunity for real estate investors

SMB acquisitions target tenured, stable operating companies with positive EBITDA margins and free cash flow. Although most SMB deals—especially self-funded search deals—are levered with SBA debt, it’s reported that the probability of default on an SBA loan is just 2.25%. 

This risk and return profile can be compelling for real estate investors who want to gain exposure to investments with a higher return potential without significantly increasing the risk profile. 

Furthermore, the structural similarities between real estate syndications and SMB acquisitions allow real estate investors to review and do due diligence on a comfortable alternative asset class. This familiarity means that real estate investors can be value-added partners on the cap table, opening the door to a more engaged or advisory relationship with the operator or sponsor.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.