Risks of Real Estate Syndications
A real estate syndication, like any investment, has risks. In a real estate syndication, the passive investor places their capital into a project that is led by someone known as the sponsor, aka the general partner. This sponsor is in charge of sourcing the deal, acquiring it, putting together the team who will manage it and implement the business plan, and raise the capital required to do this. The general partner is also the one who signs off on the loan required to purchase the property, which means they take on the most risk.
For context, most real estate syndications finance up to 75% of the property’s purchase price. That means that the rest of the 25% is typically either the general partner’s money, or it is capital raised from passive investors. In this scenario, the “lender” is technically the biggest investor in the deal, because they’re financing an overwhelming majority of it. The person who signs on the loan (the key principal) is often a member of the general partnership team, and this person has the most risk in the deal. We won’t get into the minutia of this topic, but there are different types of liability for the person signing on this loan (non-recourse vs recourse).
The point is, passive investors should understand the risks associated with their role in a real estate syndication. While they don’t have active involvement in the day to day management of the deal, their money is at risk, so education and awareness is key.
Aside from reading all of the documents before you sign, such as the operating agreement, PPMs, and legal documents, here are a few of the common risks of multifamily syndications with a value-add strategy.
Risk #1: Higher Expenses Than Anticipated
Value-add investors will estimate the cost of the renovations they plan to do at the property in order to “add value” and justify higher rents. Expenses also include the cost of owning, maintaining, and operating the property.
However, these costs can be more expensive than the sponsor initially expected and accommodated for in their underwriting. Higher expenses can be a result of:
Unexpected repairs or maintenance issues popping up
Higher property taxes than anticipated
Inflation and Supply Chain (as seen recently)
Reduce Risk: By learning what are typical expense ratios, you can review the sponsor’s underwriting to see if they are being too aggressive. Any assumptions the sponsor makes in their underwriting should be supported by historical data and operating evidence. Yes, the sponsor might intend to improve operations, but these changes should be projected to happen overtime, and within a realistic timeframe.
Risk #2: Value-add implementation takes longer than projected.
Implementing a value-add business plan can take longer than initially expected. Sponsors with experience should know how to structure and plan out a business plan that is reasonable and realistic. However, no one can predict the future, and unforeseen curveballs can impact a sponsor’s ability to the business plan.
Reduce Risk: A great sponsor should have experience implementing similar value-add business plans. If things take a turn for the worst, it’s important for sponsors to have sufficient cash reserves and contingency plans in place. Some of the greatest investors have emphasized the importance of having cash reserves, especially during an economic downturn.
Risk #3: Rental Projections Are Not Attainable
Many value-add deals rely on improving the condition of the property in order to justify higher rents. This means that the sponsors analyze comparable properties in the area, and use these to determine how much they can increase rents at the property. But it’s obviously possible that the sponsor won’t be able to increase rents as high as they’d projected. So what happens then?
Reduce Risk: An error like this can happen when the sponsor is not experienced in or educated on the inner workings of the market. Investing with sponsors that have experience in the market the investment opportunity is located in is a great way to mitigate this risk factor.
Risk #4: Poor Property Management
Unfortunately, sometimes property management companies can underperform. They might not do what they are supposed to, or do a poor job of implementing the business plan.
Reduce Risk: General partners can avoid this, and a messy property management change if they already have a pre-existing relationship with the property management. When possible, working with a property management company that the sponsors have experience with can keep you from being part of a deal that’s essentially a trial run.
Risk #5: Market Changes
Markets are volatile by nature. The market is part of a cycle, and as you’ve likely heard, what goes up must come down. The unpredictability of the economy can have a major impact on the value and cash flow of multifamily real estate. If a sponsor’s value-added business plan depends on being able to sell the asset at a higher price post-renovations, there needs to be demand for the asset at that price.
Reduce Risk: Sponsors and investors who have historically survived and performed during economic downturns usually incorporate cash flow, long term leverage, and cash reserves as part of their business plan. This helps them navigate the tumultuous waters of a dipping economy.
There are multiple risks when it comes to value-add investing. Most of these risks can be mitigated by taking the right steps to vet your sponsor and the investment opportunity, but real estate will always involve some level of risk.