Here Are 9 Disadvantages to Investing in Real Estate Syndications
“Come on. It sounds too good to be true!
You can’t tell me it’s this good. There must be some downsides.”
There are.
And don’t let anyone tell you there aren’t! Like every other investment, real estate syndications have potential pitfalls that you need to look out for before investing.
I’ve just entered my third decade as a full-time real estate investor. So I’ve seen a lot. Though my firm, Wellings Capital, and I could participate in numerous opportunities to make money in real estate – we prefer investing in private real estate syndications.
But we know the risks. We look out for the pitfalls and invest accordingly. My goal in this post is to give you a peek behind the curtain to consider what could go wrong…and where you could get burned.
#1 Overheated Market
I don’t know when you’ll read this. But as I write this, in the Fall of 2021, we are in an unprecedented bull real estate market. Appreciation has gone longer and higher than any time in living memory. Even a pandemic didn’t put the brakes on this crazy market.
Some of you may be turning to syndications because you can’t find a home to flip or a rental property to acquire. But keep in mind that these same forces are affecting the commercial real estate market.
A well-known syndicator just confided in me that he’s selling all his multifamily properties acquired before this past year. Buyers (both hungry and foolish) are overpaying for commercial assets by up to 20% or 30% in some cases. They are either miscalculating the numbers, gambling on appreciation, or satisfied with low returns.
Do you want to be in a deal like this when the music stops? Sure, it’s possible inflation will continue to cover these sins. But do you really want to count on that?
A potential solution…
At this stage of the cycle, we only invest with operators who have a documented edge. This secret sauce may come in the form of a repeatable arbitrage opportunity. For example, a syndicator I know buys land at its market value and harvests the timber. But he also knows how to utilize new carbon offset rules to create a cash flow machine on this property for decades…while new timber grows back.
Or the secret sauce could be an inside track on tax abatements. Or an acquisition team skilled at finding mom-and-pop deals with substantial meat on the bones in the form of untapped income and appreciation opportunities that the previous owner didn’t know or care about.
#2 Syndicators make money even if investors don’t
Syndicators typically get acquisition fees, loan fees, annual asset management fees, disposition fees, and other fees not related to performance. Many of these fees are payable whether the investors make money or not.
This is a potential misalignment of interests. And it will likely go unnoticed in an era of a rising tide that raises nearly every boat. But every market is cyclical. Trees don’t grow to the sky. But as Warren Buffett says, these clocks have no hands, so we have no idea when that time will come. Not all of these fees are bad, you just want to understand what fees are paid and in what order. We like to see a balance of up front, ongoing, and performance related fees. It’s hard to tell what fees are egregious until you start comparing and contrasting what’s out there.
A potential solution…
Look for syndicators who go out of their way to put investors first. Try to find managers who have a history of paying investors to their own hurt when things go poorly. Compare and contrast PPMs (Private Placement Memorandums) to understand fees fees and see which operators best align with their investors.
#3 Over-alignment
Though this is uncommon, it is possible for syndicators to be too aligned with their investors. How? If the syndicator offers cumulative preferred returns (the hurdle rate that cash investors receive before syndicators get a profits interest) that are too high, and cash flow is delayed, it’s possible the investors’ deferred cash flow will be so far behind as to discourage the syndicator from passionately making continued efforts to fix the problem.
For example, if the annual cumulative preferred return rate is 8%, and an asset averages cash flows of 5% for five years, the investor will be 15% behind on his cumulative return (5 years times 3% preferred return).
But if the syndicator sets a preferred return rate of 12%, and the asset cash flows at zero for five years, he will have to pay investors the first 60% in cumulative cash flow before he gets his share of profits. If this seems too daunting, and the syndicator has other, better opportunities, he may become discouraged and turn his attention elsewhere, where he is more likely to make a profit. And he may fall behind in marketing and needed capital improvements, which could exacerbate the problem.
A potential solution…
Misalignments “in the investors’ favor” often come about as the result of overconfident syndicators with cocky growth projections or ground-up deals with higher risk. Look carefully at the track record, team, and asset class of the deal you’re considering. It’s not all about ROI. It’s about the risk you take – the potential loss – to get this return. Review the whole picture carefully before wiring your funds.
#4 Loss of control
Many investors like real estate for the tax benefits, predictable cash flow, and historical appreciation. But some have an additional reason: controlling one’s destiny. Look at the increase in self-directed IRAs. And consider it’s often the desire for control that drives these decisions.
If you’re a control freak, you may want to think twice before investing in real estate syndications. Because you’ll be handing your hard-earned capital over to someone you don’t know that well. And you’ll be trusting them to make the very best decisions to protect your back and grow your wealth. Will they do everything you would do if you were in their shoes? Maybe not.
And except for extreme circumstances, you probably won’t get a vote on a syndicator’s decisions. You won’t want to vote. Because voting usually means something has gone terribly wrong with the syndicator or the deal. And voting means you’ll be at the whim of a potentially angry majority who doesn’t have the skill or experience to make these calls.
A potential solution…
If you have the time, talent, and desire, you may want to stick with small rentals or flip houses. Though there are significant risks and hassles that come along with those investments, at least you can keep your hands on the controls. If you lose money, you’ll only have yourself to be angry at.
You can also partner with someone to syndicate your own deals. This takes significant experience, skill, and a seasoned team.
#5 Dilution from over-raising
It’s tough to find cash-flowing deals these days. Investors are accustomed to getting 5-8% CoC in the first year of operations, and the fact is that these deals are less common these days.
The solution, for some syndicators, is to raise extra capital to pay investors until cash flow catches up to projected returns. We have seen more and more syndicators doing this, especially newer syndicators raising money from those new to private real estate investing. You will often find two classes of investor shares in this structure: one with a fixed-rate return and one with a greater profit participation upon sale. This assumes rents will continue to rise, and expenses are held in check. At best, this dilutes investor returns because it spreads the same amount of cash flow over more investor equity. At worst, it could be ruled illegal (though I’ve never heard of a ruling in this regard).
A potential solution…
Ask the syndicator hard questions. Review pro forma projections. Have them confirm (in writing) that they are not using raised capital to pay investor returns and ask them to defend their rising income projections. Check to see if their track record supports their projections and if their references confirm their history.
#6 A rising tide makes even newrus look good
“What’s a newru?” you ask. As I said, this has been an unprecedented run. Combine this bull market with loosened restrictions from the 2012 JOBS Act (that opened the door to Regulation D, Rule 506 syndications), a plethora of coaching programs, and a rapid increase in social media and crowdfunding, and we’ve got an explosion of new syndicators.
These syndicators have never seen a down market. And some believe “things are different this time.” Even worse, they are better promoters than operators, and some have even set themselves up as gurus instructing others. New gurus. Newrus.
They’ve made insane amounts of money over the past 5-8 years. Their investors have made countless millions. And with the rise in inflation, they may continue on this path. I wish them all the greatest success.
But I worry that in some cases, they have turned a stable, predictable, cash-flowing investment…into a Las Vegas-style speculation. Speculators make a lot of money – when they win. But they also risk losing everything, including their projected cash flow and their invested equity.
A potential solution…
You may be OK with speculation—more power to you. But if you want to truly invest, look for predictable deals from syndicators who have a long track record owning and operating their asset class. Operators who have provided stable returns to their investors from the same asset class for a long time.
These deals may be less glamorous and promise lower projected returns. But don’t forget Mr. Buffett’s first and second investing rule: “Don’t lose money.”
Speaking of losing money…
#7 Risky Debt
Dave Ramsey famously hates on debt. But he’s speaking to an audience primarily consisting of consumers who get in trouble with debt. Real estate investors know that safe debt (leverage) is the key to equity acceleration and wealth creation.
America’s top real estate investor, Sam Zell, says that the use of fixed, low rate debt was one of the keys to his massive wealth accumulation. And he was referring to debt in the 7% range! Of course, inflation was in the double digits those days.
It’s not only consumers who get in trouble with debt. Over-zealous syndicators find multiple ways to get in trouble with debt. And their investors may end up picking up the tab. How does this occur?
High LTV. High loan-to-value ratios can significantly accelerate the return on equity. A commercial asset’s value = Net Operating Income ÷ Cap Rate.
So, for example, increasing rents by 20% can increase profits (NOI) by 30% or more (assuming expenses don’t rise accordingly). Increased NOI of 30% leads to asset appreciation of 30% (assuming equal cap rate). 30% is a great return. But the bankers don’t share in this return. Add in 75% debt, and the equity appreciation is roughly 120% (30% * (1 minus .75) = 120%).
This is irresistible for most investors and operators. But realize this can work against you as well. Drop rents by 25%, and income drops by 25%. Asset value correspondingly drops by 25%. Equity value, with a 75% LTV, may go to zero. Not a fun day. (And note this could make it impossible to refinance without injecting additional equity.)
Short-term debt. Many bridge loans and interest-only loans have relatively short terms. Syndicators often get high LTV, low rate, short-term loans to increase early investor returns. They usually assume they can improve income enough to refinance into a fully amortized loan soon or that cap rates won’t expand (driving prices down). And they assume bankers will be eager to make high LTV loans when the term is up.
This has all kinds of potential for risk. Syndicators who used this type of debt in the years leading up to 2008 found themselves bankrupt, and their investors lost a lot of equity.
Floating rate loans. Most of the loans mentioned in #2 above have floating interest rates based on the current treasury. Syndicators assume rates won’t go up. But if they do rise, it may cause double trouble. First, this will increase their monthly debt service. Second, it will likely mean a higher rate when they refinance into permanent debt. And it could mean a lower appraisal at that time.
If the operator doesn’t increase property income to compensate for these factors, he could have big problems. As a passive investor in a deal like that, you may be getting a worried call to send along more capital. And you could end up throwing good money after bad.
A potential solution…
Invest with syndicators who utilize debt responsibly. Ask them to stress test their debt and prove it works in poor economic conditions. Carefully analyze their track record and their reasoning for using this type of debt. It may be a home run…or a disaster in the making.
#8 Minimal or zero skin in the game
When looking for alignment between syndicator and investors, there is no substitute for this. Syndicators may put thousands of hours into a deal, but when their cash is at risk, this somehow makes things feel different. They react differently to trouble. They are now both the general partner and a cash investor in the deal.
I know one or two syndicators who don’t put cash in their deals. I know a few who take an acquisition fee at closing and reinvest that as their skin in the game. I don’t think either of these is wrong necessarily. But we don’t invest with any operator/syndicator/sponsor who doesn’t have their personal cash in the deal on the same terms as other LPs.
#9 Key man risk
I think there are a lot of downsides to investing on Wall Street. But one advantage is the depth of the bench at large corporations. So if their CEO drops over or gets hit by a bus (why is it always a bus?), the board can usually hire a star replacement. Even Apple’s replacement for Steve Jobs has gone quite well these past eight years.
Investing with many syndicators carries the risk of losing the star player. Many syndication companies are built around a big personality with a lot of talent and experience. Their deals may suffer if they’re suddenly out of the picture.
A potential solution…
Check out their organizational chart and succession plan. Ask hard questions about who will take the wheel if they aren’t there and how they are training up the next generation of leaders. From what I’ve seen, most of the best operators have a dedicated, cohesive team of A-players with a long track record. This is ideal. A lone ranger with a bunch of contractors is typically not.
Summary
As usual with my articles, this list above is not exhaustive. If you’re passively investing in commercial real estate, find a great syndicator. Try to minimize the downsides I laid out in this article. Look for significant upsides as well. Meet them in person if practical to get a gut feel for their character and truthfulness. Meet their team. Study their track record. Check their references and Google them in detail. You’ll learn a lot.
Please reach out to us if you’d like to discuss this article or learn more about passively investing in commercial real estate. Our team will be glad to assist you with any questions you have about any deals you’re considering or one of our offerings in particular.
If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call to see if Wellings Capital’s investments are a fit for you.
Happy Investing!
As with all financial matters, please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.