How to Avoid Losing Money in a Real Estate Syndication or Fund

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Unavoidable Risks

Whether you are an active syndicator, fund manager, or a passive investor, losing money in a real estate syndication or fund is a real concern. Often, it happens due to unavoidable circumstances, such as:

• Environmental damage to a property that insurance doesn’t cover
• Real estate market cycles that cause property values to decrease
• Interest rate increases making financing less affordable for buyers
• Government rent or eviction controls that prevent eviction of non-paying tenants or limit rent increases
• Rising insurance costs, building supply costs, or labor shortages
• Tax law changes
• Zoning changes

These things are typically beyond the control of a syndicator or fund manager, although some are predictable. The best way for active syndicators and fund managers to avoid losses due to unavoidable risks is to:

Educate yourself about the risks associated with real estate, and in particular, the markets and asset classes you are considering.

1. Get training, attend conferences, read books, listen to podcasts, and find coaches or mentors who can help you avoid these missteps.
2. Learn about real estate market cycles. Real estate prices rise for some time, and then they fall. But real estate prices always recover and eventually increase beyond what they were before. You’re in good shape if you’ve been conservative with your loans and have long enough maturity dates that you can ride it out. You’re in bad shape if your loan comes due when real estate prices are depressed so that you can’t sell or refinance the property for its current loan balance. Your only options there are to take a loss or raise more money to get into a new loan.

Be conservative in your projections. Assume everything you want to do with a property will cost more and take longer than you think. Many real estate investors who lost properties in the Great Recession (and seemingly this one), bought properties with loans with short maturity dates of 1–3 years, instead of paying a higher interest rate or points for a 5–10-year maturity date. Many accepted adjustable mortgages and high loan-to-value ratios. Many of those who personally guaranteed loans in the last recession had to declare bankruptcy and some even had to pay taxes on the deficiencies. The way to hedge against such losses is to keep loan maturity dates long, loan-to-value ratios low, and pay whatever it costs for a fixed rate for a longer term.

Learn about syndication (pooling funds from passive investors with an active asset management team) and how to comply with securities laws.

1. The primary role of securities laws is to protect the investing public.
2. Securities laws obligate you to ensure that investors have all the material facts they need to make informed consent before they invest. You must educate your investors about these risks. This is usually done through a private placement memorandum and providing detailed information about the property, the corporate structure you will use to acquire and own it, and the proposed plan of operation.
3. Additionally, you must ensure that all investors have the requisite financial qualifications and sophistication to understand the risks and that they can afford to withstand a loss.
4. If you follow securities laws, you actually have some protection against investor lawsuits that arise over something you warned investors about that was beyond your control. If you don’t follow securities laws, which usually means you didn’t adequately warn them, they’ll claim they wouldn’t have invested if they had known — and that you failed to provide all of the material facts.

If you’re a passive investor, seek syndicators or fund managers who have a sufficient track record of owning and syndicating similar asset classes to be able to recognize and minimize these risks.

What Are Some Avoidable Risks?

The most obvious avoidable risk is fraud. Below are some examples of fraud that can occur in a real estate syndication or fund, and how you can avoid them:

Embezzlement

This generally occurs when someone with access to the company’s bank account withdraws funds or pays themselves without authorization to do so.

There is a doctrine called the “triangle of fraud.” This triangle consists of three elements:

1. Access to funds
2. Pressure or incentive
3. Justification

This is what forensic accountants or criminal investigators look for when funds have disappeared.

The incentive could be something innocent, such as medical bills, unexpected expenses, or loss of employment, or it could be nefarious, such as gambling debts, living beyond their means, or someone who is an actual conman or thief. Almost all complaints by the Securities and Exchange Commission (SEC) citing fraud mention that investor funds were spent on expensive cars, homes, and luxury vacations; often with a complex scheme where spouses or relatives took title to the goods. The embezzler will often borrow the funds with a plan to pay it back; thinking when this or that happens, they’ll be able to repay it. When they can’t, they try to justify why they were entitled to it — until they eventually get caught.

How Can You Spot Embezzlement?

Pay attention to the company bank account. Look for:

• Unauthorized transfers to unknown bank accounts
• Large payments to unknown recipients
• Frequent ATM withdrawals
• PayPal, Venmo, or Zelle payments to individuals you don’t know
• Checks written to certain members of the management team or their affiliated companies (hint: require dual signatures on all checks to any member of management)
• Transfers or cashed checks labeled as “advances on future pay” or “purchase of interests” in the company
• Payments made to personal credit cards or for household expenses

How to Prevent Embezzlement

The easiest way to prevent this is to make sure that multiple people have viewing access to the bank account and that they look at it regularly. If you are in the management team of a syndication, ask for viewing access. If you are a partner in a joint venture, insist on it.

Immediately question any suspicious withdrawals, checks, or transfers. Usually, these things start small. When the embezzler gets away with it, they do it again, often on an increasing scale. Sometimes it takes years for anyone to figure it out, and by then, millions of dollars may be long spent and irrecoverable. Those stories sometimes hit the news.

At least two unrelated people should have signatory access to company bank accounts, and even more can have viewing access. All people with viewing access should be checking the company bank accounts weekly at a minimum.

Knowing someone else is watching is the best prevention. If you discover embezzlement, you will need to let everyone in management know about it and remove that person from access to company funds (and management) immediately. Make sure your documents allow this, but you might have to hire an attorney to help you remove them. If someone has been stealing, they are unlikely to put up much of a protest to being removed, but it is unlikely to happen without drama.

You could be held responsible for the losses if someone in your syndication or fund management team embezzles funds. Pay attention and don’t let it happen.

Ponzi Schemes

This happens when new investors are sought to pay promised returns to previous investors. Those left without a chair when the music stops (and it eventually does) will lose their investment. Do an internet and social media search for the names of all individuals who are promoting the offering before you invest — or before you actively participate in management with others you may have just met. If they’ve already harmed some investors, others may have reported it.

Don’t just look at the first page on an internet search; look three or four pages deep. Reputation management companies try to bury bad press by flooding the web with positive information. Dig deep. Don’t be in a deal with anyone with a history of lawsuits, criminal activities, being terminated from jobs, filing bankruptcy, or any other acts of dishonesty.

Misrepresentation

This can occur when someone either omits material facts or misleads investors about things that may have influenced their decision to invest. Material facts could be about things like:

• The promoter’s role in the project. Are they just raising capital, or will they be involved in management?
• The project itself. For example, does zoning need to be changed for a development project to be approved? How likely is that to happen and how far along are they in the approval process? How many similar development projects and zoning changes has this developer done?
• The prior experience of the management team. Are certain members experienced while others are not? How involved will the experienced members be in management? Hint: Sometimes people just lend their financial statements and resumes for a fee without any real involvement in management. Make sure the people with the experience are actively involved in the project.

Carefully review all of the documents provided and ask questions until you are satisfied with the answers.

About the Author:

At SyndicationAttorneys.com, our mission is to help our clients understand their obligations to their investors, teach them how to comply with securities laws and properly structure their deals, and help passive investors learn how to protect themselves. Check out syndicationattorneys.com for one of our free books on How to Raise Capital Legally, and schedule a call if you want us to create or review an offering for you. 

Disclaimer:

The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.