The Risks in Real Estate Syndication Investing
When you invest in a real estate syndication, you are investing in a project that is being sponsored by a party known as the “sponsor.” The sponsor is typically responsible for finding and acquiring the property, assembling the team to manage it, and raising the money to fund the deal. They also take on most of the risk associated with the investment.
It’s important for you as a passive investor to understand what those risks are so you can make sure they have been mitigated. In this blog post, we will discuss some of the common risks in value add multifamily real estate syndication investments and how sponsors try to mitigate them. This is not an exhaustive list but does cover some of the most common risks.
Passive investors are always depending on sponsors in real estate deals, particularly in this area. Always be sure to read and understand all legal documents, Operating Agreements, PPMs, and other information provided by the sponsor in full.
1. Expenses Higher than Expected
One of the risks in real estate investing is that expenses can be higher than expected. This can happen for a variety of reasons, such as unanticipated repairs or maintenance costs, higher than expected property taxes, insurance, and much more. When this happens, it eats into the returns that investors can expect to generate – sometimes catastrophically so!
How to mitigate this risk
Learn typical expense ratios so you can do sanity checks on the deal, to make sure the sponsor isn’t being too aggressive. Make sure the sponsor is basing their projections off of historical operating data. They will likely plan to make changes to the operations which will change the expenses, but those changes take time to impact the property.
Verify that the sponsor is doing thorough physical and financial due diligence on the property. A reputable sponsor who is taking these steps can identify and mitigate most of those risks.
2. Value add time frame takes too long
Sometimes executing on a value add strategy takes longer than planned. Experienced sponsors should be able to make reasonable, executable business plans, but things can still go wrong.
Consider a deal that is financed for two years, with a value add strategy planned to take less time than that. What if the execution of value add takes longer than the debt allows?
How to mitigate this risk
Make sure the sponsor is experienced in executing similar value add strategies. Things can still go wrong, though, and this is where reserves and contingencies come in. Make sure the investment company will have adequate cash reserves to weather storms!
3. Rent Comps Were Wrong & They Can't Push Rents as Far as Expected
Most multifamily value add business plans will depend on making property improvements and raising rents. The sponsor will usually look at comparable properties to determine how high they may be able to raise rents, then they’ll make their business plan and projections based on those numbers.
But what if they can’t raise rents as much as they thought?
How to mitigate this risk
This often comes down to the sponsor not being knowledgeable or experienced in the market. If they don’t know the city well, how good can their market knowledge really be?
I prefer to invest with sponsors who are already experienced in the city where they’re buying.
4. You need your money back early
One of the risks of real estate syndication investments is that you may need to exit the investment early. This could be for a variety of reasons, such as personal financial difficulties, changes in the market, or problems with the property itself. If this happens, you may wind up in a bind. Real estate syndications involve restricted securities, meaning an investor’s ability to resell their interest is limited.
There are limitations on both when you can sell and to whom. Your legal agreement with the sponsor will typically include a process by which investors can sell their interest. You may be required to give the sponsor first right of refusal, then approach other investors to buy your interest. Always read and understand legal documents in full!
How to mitigate this risk
It’s important to have a personal emergency fund to cover your own expenses in the event that you need to exit an investment early. It’s also important to diversify your investments. Don’t put all of your eggs in one basket!
Real Estate Syndications (and real estate generally) are illiquid investments. Having too much invested in illiquid investments can make finances difficult when unexpected things happen.
5. Underwriting mistakes - sponsors can make math errors
Deal sponsors are people too, and people sometimes make mistakes. Sometimes those mistakes come in the form of math errors when underwriting a deal. This can lead to big problems down the road if the sponsor is relying on those projections to make their business plan work.
How to mitigate this risk
Make sure you understand the numbers that the sponsor is using in their projections. Checking the sponsor’s math can go a long way.
This is another area where experienced sponsors can stand out from newbies. Experienced sponsors will likely be using well-tested underwriting models that have been proven on prior properties.
6. Materials and labor are not available when needed
If materials and labor are not available when needed, it can cause delays in the value add process and lead to cost overruns. Some deals’ business plans can hinge on a specific value add timeframe. If the plan is to raise rents within 12-18 months, but you can’t get the contractors and materials to make it happen in that timeframe, what happens to the deal?
How to mitigate this risk
Make sure the sponsor has a solid plan B in place in case of delays. The best way to avoid this issue altogether is to invest with a sponsor who has a good relationship with local vendors and contractors. This is why it’s important to have an experienced sponsor who knows how to navigate these challenges and adequate reserves to weather these types of storms.
7. Property management underperforms, misbehaves, or outright steals
Unfortunately it happens. It has happened to me! Sometimes property managers don’t do what they’re supposed to, even to the point of stealing. In my case, the property manager allegedly stole a considerable sum of money from us by overbilling contracting work and other means.
The General Partners took swift action as soon as the theft was uncovered, replaced the Property Manager immediately, and began legal proceedings against the misbehavers. The damage was done, however, and thus began a multi-year legal battle. We still did well on that property, but things could have gone much worse.
How to mitigate this risk
The best way to avoid this issue is to invest with an experienced sponsor who has a good relationship with their property manager.
8. Sponsor commits fraud
Unfortunately, sometimes it happens. While it’s not common, there have been cases of sponsors committing fraud through multiple means. Misappropriating funds, doctoring financial statements, and using investor funds for personal expenses are just a few examples.
How to mitigate this risk
There are a number of ways to help mitigate this risk. Performing Background checks on the sponsors, obtaining and checking multiple references, good old fashioned Google searches, and asking investor forums like Biggerpockets can help a lot.
9. Market Risk
All markets are volatile, and the economy generally can be unpredictable. These facts can impact the values and cash flows of real estate. This risk is especially relevant for value-add properties, where the business plan may rely on being able to sell the property at a higher price after the renovations are complete.
New development also includes a strong degree of market risk. If a new development is scheduled to take 2-3 years, the business plan will heavily depend on the strength of the market at the time of sale. If the market takes a dive those new development investors can have a difficult time realizing a return at sale.
How to mitigate this risk
This is one of those risks which is particularly difficult to predict. Investors who tend to survive and thrive in down markets typically have 3 things as key aspects of their business plan: cash flow, modest long term leverage, and cash reserves.
Wrapping it up
In conclusion, there are a number of risks associated with value add multifamily real estate syndication investing. Many risks can be mitigated, but it is important to remember that even the best due diligence and risk mitigation may not totally protect investors. Real estate investments carry risk of loss.
Experienced investors look to earn strong returns while limiting downside risk as much as possible.
