There are endless real estate syndications that target returns in the mid-teens and higher.
But some of them are riskier than aging buffet sushi, while others come with low risk. So how can investors differentiate the risk of syndication deals?
One answer to that question is “Spend hours performing deep due diligence and picking through the pro forma.” But that doesn’t help you filter out high-risk deals quickly, in order to save your deeper analysis for only the most promising deals.
Our real estate investment club meets every month to vet and go in on passive deals together. Suffice it to say that I look over a lot of deals, and I need a quick framework for filtering them by risk.
Here’s that framework, to quickly decide if a deal is worth a closer look.
1. Debt Risk
This month, our Co-Investing Club invested in a land fund that uses no debt at all.
That’s unusual, however. Most real estate syndicators leverage debt to reduce the cash they have to raise and the profits they have to split with investors.
But there’s debt — and then there’s debt.
What’s the loan-to-value ratio (LTV)? How about the loan term? What’s the interest rate, and is it fixed or floating? If the latter, what kind of protection did the sponsor put in place against rising rates?
These factors all affect the risk in a real estate deal.
As a final thought on the matter, consider that syndication deals fall apart for one of two reasons: the sponsor runs out of money or runs out of time. Debt can cause either of those cases.
Uncapped floating interest rates can drive deals to negative cash flow and the sponsor can run out of money. And short loan terms can force sponsors to sell, refinance, or recapitalize in a bad market, creating a loss for investors.
2. Property Management Risk
Don’t ask “Is the property management in-house or outsourced?”
Well, do ask that question, but then follow up with a more important one: “How many properties has this management team overseen for you?”
It doesn’t really matter whether the property management is outsourced or in-house. The track record of working together on many deals is what matters. I want to hear sponsors say, “This management team has worked with us on 20 deals,” — or 10, or 30, or whatever — but not, “We’ve only worked with them once before,” or never.
When syndication deals fall apart, they usually do so because of a cascade of problems, to borrow terminology from aviation crashes. Many factors usually go wrong to crash a syndication deal. And one of those factors is almost always poor property management.
3. Construction Risk
The same principle applies to construction and renovation teams: How many deals has the sponsor worked on with them?
In-house or outsourced — that doesn’t matter as much as a successful working relationship going back hundreds or thousands of units.
Our Co-Investing Club doesn’t want to invest in deals that require hiring untested teams to run renovation or construction projects. You shouldn’t either.
4. Market Risk
Yeah, yeah, I get it: none of us can predict future market movements.
But we can invest in deals with lower exposure to market risk than others.
That starts with simply looking at the sponsor’s projections. Do cap rates have to stay the same, or worse, drop down in order for the deal to turn a strong profit?
What kind of rent growth has the sponsor projected? Is it above 3% per year (aside from forced jumps from renovations)?
Conversely, what kind of growth in expenses has the sponsor forecast? These should be forecast to grow faster than rents, as a prerequisite for considering any pro forma “conservative.” Look no further than how much faster insurance premiums and labor costs have risen over the last few years than rents have.
How much of a cash reserve has the sponsor budgeted? The higher the cash reserve relative to the overall acquisition costs, the lower the risk in the deal.
I don’t know when the next recession will hit, but I know it’ll come sooner or later. And when it does, I don’t want any of our Co-Investing Club’s deals to result in a loss.
5. Regulatory Risk
Over the last decade, more tenant-friendly states and cities have passed increasingly anti-landlord regulations. Look no further than New York, which just this year passed a “just cause eviction” law. Don’t be fooled by the misnomer — the law isn’t about evictions. It’s about forced lease renewals, taking away the owner’s right not to renew a lease contract.
That says nothing of the eviction moratoriums that hit landlords on the federal, state, and local levels in 2020-2022. Or the nationwide rent stabilization laws that a presidential nominee has proposed.
The residential rental industry continues to see more and more regulation. I expect that trend to continue, and you should too.
You can reduce regulatory risk by investing in non-residential real estate. Remember that land fund that I mentioned at the top? You don’t hear any presidential candidates calling for “just cause eviction” laws for raw land. In the worst-case scenario, a buyer with seller financing defaults on their loan, and the fund manager forecloses within a few short months. No muss, no fuss, no lawsuits. The borrower simply forfeits their right to camp or hunt on the land parcel.
That doesn’t mean our Co-Investing Club never invests in multifamily properties. But we do consider the regulatory risk. Does the property sit in a tenant- or owner-friendly state and city? If it sits in a tenant-friendly jurisdiction, is there a glaring, overpowering protection in place against the high regulation?
If not, we pass.
6. Concentration Risk
One of the greatest barriers to passive real estate investing is capital. Most syndications require a minimum investment of $50,000 to $100,000. Some require as much as $250,000 or even $1 million.
For that matter, it costs just as much to buy properties directly, when you add up the down payment, closing costs, cash reserves, and initial repair costs.
That means middle-class investors must concentrate a lot of their capital within each investment they make. If one of those deals goes sideways on them, they’re in real trouble.
I never liked that concentration risk. So I invest $5-10K at a time, knowing that my real estate investment returns will form a bell curve.
A few will underperform. A few will overperform and hit it out of the park. Most will perform in the middle of the bell curve.
But you don’t see that bell curve when you can only invest in one deal a year. You just pray that your one deal doesn’t underperform.
In fact, this is the exact reason my partner at SparkRental and I created the Co-Investing Club: so we could go in on passive real estate investments together and each person could invest with less.
I invest every month as a form of dollar-cost averaging my real estate investments. That means I don’t have to do stupid things like try to time the market or predict the next hot asset class. I just keep investing, slowly and steadily, month in and month out.
Beyond Syndications
I like syndications. But they’re far from the only passive real estate investment I like for our Co-Investing Club.
We also love private partnerships, private notes, real estate equity funds, and real estate debt funds. We partner with house flippers, spec home developers, land flippers, and more. We lend money on low-LTV secured notes. And we spread money even further with funds.
I consider myself agnostic on property type, location, sponsor/partner, deal time frame, and deal structure. Instead, I focus on diversification — and I sleep at night knowing that the law of averages will protect me as long as I keep investing small amounts every month and don’t try to get too “clever” predicting the future.
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About the Author: Brian Davis is a real estate investor, personal finance writer, and co-founder of SparkRental with over two decades in the real estate and finance industries. He owns fractional shares in over 2,000 units and regularly contributes as a real estate and personal finance expert for Inman, BiggerPockets, R.E.tipster, and more.
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.
