Have you ever invested and lost money? If so, we can relate.
Our first time losing money was when we put $1,000 into cryptocurrency (for fun) while the Bitcoin bubble grew to $20,000 per coin several years ago. We entered somewhere around the $14,000 mark. It dropped precipitously after the high water mark and did not return for a long time. Then we sold just when it hit $16,000 or so. That was a speculative educational investment, money we were prepared to lose.
Two years ago we put the same amount into FedEx (FDX) stock on a newsletter tip. It subsequently dropped from $220 per share to a low of $106 over the course of a year.
We have always retained money in real estate, but our second house flip was nearly a disaster. We overpaid for the house and slightly over-improved it as well. In the end, we only netted a profit of $6,000. Considering the hours we spent doing our handiwork on it (alongside several contractors), we probably averaged minimum wage.
Sometimes that’s how we learn.
If you are unfamiliar with real estate syndication, we recommend reading our article “What is Real Estate Syndication?”
Just as with any investment type, it pays to do your homework. There are good deals, bad deals, average deals, and great deals. And they don’t always end up as projected initially on paper.
Some sponsors over-promise and under-deliver. Other sponsors underpromise and over-deliver. You want to partner with the latter.
When investing in company stock, management is the most critical component to analyze. A lackluster company that has significantly upgraded its management will likely thrive and be a great candidate for investment. Alternatively, a great company that has appointed a useless CEO is probably a bad bet.
Similarly, the most critical element of a syndication is the sponsor (or operator). An incompetent or dishonest (God forbid) sponsor can turn a great real estate deal into a flop, while an experienced, savvy sponsor can turn a mediocre deal into a big win. Not to mention that a competent operator is more likely to choose a solid deal to syndicate in the first place.
Here are some question you should ask to help you choose a great syndication:
- How is the operator’s track record in real estate?
- If the sponsor is not overly experienced, are they under advisement from a coach or mentor?
- Would the sponsor pass a background check?
- How much of the sponsor’s capital will he or she be investing in the syndication?
- Has the operator ever experienced a recession? If so, how did they fare?
- What properties does the sponsor currently have under management? Would the properties appear in the sponsor’s background check?
Underwriting
We can’t stress enough the importance of conservative underwriting. A bad deal can be disguised into a great deal with the wrong key assumptions. A deal projecting an annualized internal rate of return (IRR) of 13% that is underwritten conservatively might be a much better deal than one projecting an IRR of 21% that is not.
It would be best to familiarize yourself with the underwriting of prospective syndication investments or have a trusted, experienced peer check the underwriting to ensure it is realistic and conservative. If you are not versed in the language of commercial real estate, it would be helpful to have a glossary of terms on hand.
Here are some questions that can help to check the underwriting of a deal:
- What is the loan-to-value ratio? And the cost-to-loan ratio?
- How much money is being budgeted for reserves?
- Is the interest rate of the loan adjustable or fixed? Is there a rate cap if it is adjustable?
- How long is the interest-only period (if any)?
- What is the debt-service coverage ratio on purchase? And on sale?
- What type of debt is being utilized?
- Do the capital expenditures for the renovations look realistic? Were contractor bids acquired?
- What are the assumed rental rate increases? How much are comparable rents in the area?
- What is the assumed exit capitalization rate? How does it compare to the current market cap rate?
- What is the assumed occupancy rate upon stabilization? Does it match that of the surrounding market?
- What are some other underwriting assumptions, and how are they justified?
Suppose you want to verify that the assumptions are realistic and conservative. You can do homework by speaking with a trusted third-party management company or real estate broker about the prospective deal.
It’s also possible to do research online if you enjoy detective work. If your deal is a multifamily syndication, you can use Rentometer or apartments.com to find out how much similar apartments rent for near the prospective property. If it’s a self-storage facility, you can check nearby facilities to see how full they are and how much the rental rates are for the local market. Use Crexi to find out local capitalization rates for similar properties advertised in the same market.
The Market
Learning about the local area of a prospective syndication deal is also highly relevant. A heavy value-add deal in a working-class market will be more challenging (and, therefore, carry more risk) than a mostly stabilized asset in an upscale area.
Some questions to help determine whether you are about to invest in a promising market:
- How business-friendly is the administration of the local metropolitan area?
- What is the current population growth rate of the area?
- What is the prospective rate of job growth for the market?
- What is the crime rate within a three-mile radius of the property?
- How about the median household income in the same radius?
- How diverse is the employment base? More is better.
- Is the property in a flood zone or an area prone to natural disasters?
- How well does the sponsor know this market?
Again, one can verify many important aspects through local property managers, brokers, or the Internet. A valuable website for demographic research is city-data.com.
The Property
Some considerations will affect the risk profile of syndication relating to the property itself. For instance, due to improvements in materials and construction techniques, an older building will generally require a larger budget for capital improvements and will carry more risk.
Here are some things to ask about the property:
- When was the property built?
- What renovations were done by previous owners?
- How is security on the property and how will it be improved?
- What is the age of the plumbing, electrical, HVAC, elevators, and roof(s)?
- What is the history of insurance payouts on the property?
The Management
Last but not least, the property will need to be managed, and the management quality will be pivotal to the success of the syndication.
Here are some related questions:
- Who will manage the property? If using third-party management, what are their reputation and track record?
- Will the management be onsite?
- How will the management be involved with renovations?
- Which software suite does the property management use for operations and reports?
- Has the sponsor had prior experience with the property manager?
- How is the current performance of other assets managed by this property manager?
Read the Fine Print
Last but certainly not least, passive investors should always read the contracts relating to the syndication investment (or have an attorney review them) before wiring their investment capital. In practice, they rarely do so. Nevertheless, we advise passive investors to read the Private Placement Memorandum (PPM) and the LLC operating agreement. It’s always well worth the time.
Conclusion
While this is not an exhaustive manual on syndication due diligence for the passive investor, it will give him or her a few important details to consider. This post was not meant to overwhelm or scare investors away from passive investment in real estate. Indeed, we are convinced that this type of investment provides an unparalleled risk-adjusted return.
Every prospective passive investor must strive to understand some of the facets of commercial real estate investment to make informed decisions. If time allows, they should familiarize themselves with basic underwriting fundamentals, demographic research, building codes, and property management techniques. Education is always the best risk mitigation.
Feel free to schedule a quick, no-pressure phone consultation with us to learn more about our exciting opportunities to invest passively in real estate. Even if we are not a good fit for one another, we will do our best to point you in the right direction.
Disclaimer: The opinions conveyed in this article are provided for educational purposes only and should not be interpreted as an offer to buy or sell any securities or to make or contemplate any investment.
3 thoughts on “How to Select a Real Estate Syndication for Passive Investment”
Comments are closed.