Hi! Eric Garber here. I'm currently a passive investor with Regency Investment Group, and I help new investors know what to expect if they invest, too. But in 2016, I had never heard of a syndication. It wasn't until 2017 that I learned that my friends (Sarah and Alex May) were doing their first syndicated deal. In 2019, I invested in their 2nd deal. Until 2022, I didn’t know of other syndicators, but by the end of the year, I was seeing opportunities around the country to invest in everything from apartments to industrial centers to RV parks and even car washes!
As exciting as it is to see so many opportunities, it’s extremely important to perform due diligence before handing over your hard-earned money for a new investment.
Just as you’d determine criteria or a ‘buy-box’ for purchasing your own real estate, you need to create a buy-box for your passive real estate investments, too. The benefit of implementing a buy-box is that it helps hold you accountable to the pre-determined criteria, preventing you from getting emotionally attached and potentially buying a property you will regret down the road.
If you haven’t heard of a buy-box before, this is a list of key criteria you use to evaluate the goodness of a property and may include things like the neighborhood, number of bedrooms, price point, cash-on-cash return, garage, HOA, age of build, age of roof, etc.
While there are many things to look for before deciding to invest a particular passive real estate deal, here are my top 5:
1. Can you trust the sponsor(s)?
When you invest as a limited partner in a passive real estate deal, you are literally going into business with the syndicator(s). Make sure that you trust that they have unflappable integrity because their actions for the next ~5 years may be the difference in you receiving healthy returns or losing your entire investment.
If you don’t know and trust the sponsor already, one simple thing that helps you know they will be making decisions that put investors first is if:
They are investing a significant amount of their own money in the deal.
It is perfectly acceptable to ask the sponsor(s) how much of their own money they are investing as limited partners.
Please do understand that there can be situations that out of the control of the syndicator, no matter how trustworthy they are.
2. Sponsor(s) experience
A great sponsor can salvage a challenging deal, while a bad sponsor can ruin a great deal. Ideally any sponsor you are considering will have taken deals full-cycle (i.e., successfully executed the business plan and sold a property) and the returns were in line with their original projections (or better!).
You also want to review how their current deals are performing. Are they performing to plan? Have they had any issues? If so, what have they learned and what systems have they put in place to prevent these issues in the future? For newer sponsors, they may not have had enough time to take any of their deals full cycle yet, but you can still review their current deals.
When this is a sponsor’s first deal, or their first deal of this particular asset class, you will want to look at who they are partnering with and why they believe they can be successful. This is also a time when you will want to consider their previous experience outside of syndicating real estate. If they were extremely successful in other roles that would give you faith they can succeed as a sponsor, it’s ok to take a chance on them if you know them well. Otherwise, I’d seek out a sponsor with more experience for your hard-earned investment dollars.
3. Market/Location
Is the property in a market that has a strong and diverse business base? Specifically, you should look for positive business growth and no single sector having more than 25% of the jobs (e.g., Technology, Health Care, Energy, Financial, etc.). It is also helpful to understand if the available jobs offer higher paying salaries or not, as higher salaries can help support rent increases. Finally, make sure that the market has been experiencing population growth, and it is projected to continue.
4. Business Plan
The business plan lays out how the property is going to be operated and improved as well as the expected returns an investor will receive. There are a lot of things included in the business plan, but if I had to recommend a couple of areas to focus on, they would be the value-add projects and the financials.
For the value-add projects, you should look to see what type of renovation work is planned and if the sponsors have performed that type of work on previous deals. If so, make sure to ask how their projected budget and timeline compare to previous deals and look for any discrepancies.
E.g., if they are planning a refresh that includes painting and installing luxury vinyl plank flooring for $2K per unit with a completion of 6 months for the complex, but when asked they say the last property, they executed this on cost $3K per apartment and took 12 months, you will want to ask for more information. It could simply be that the last one experienced supply chain or labor issues and those have been resolved, but it could also be that they are being too optimistic.
For the financials there are a few areas to pay special attention to: the projected rent increases, the exit cap rate assumptions, and how investor returns are being calculated.
- Projected rent increases - make sure future rent growth projections are based on industry data or are no higher than 3% annually. Also check that there are clear comparable properties that show that the future renovations will support higher planned rents.
- Future property tax rates – most cities will reassess a property’s taxes based on the price that the property was sold for, so make sure that the business plan accounts for this potentially significant expense increase.
- Exit cap rate - make sure that they are assuming a higher cap rate at exit compared to purchase, otherwise unexpected cap rate expansion could severely impact investor returns.
Traditional approaches typically increase the cap rate by 10 basis points per year (for a 5-year hold this would mean the exit cap rate would be projected 0.5% higher than the current cap rate) or use industry data sources.
- Investor returns – watch out for inconsistencies between different metrics. Some people like internal rate of return (IRR), some like average annualized return (AAR) and some like equity multiple (EM). Regardless of which one you like to use, make sure you understand what is going into it.
For example, I reviewed another syndicator’s deal package in 2022 that calculated the EM using an 8-year hold. This means that if you were comparing this deal to another that used a 5-year hold to calculate EM, you could mistakenly believe the 8-year EM yielded a better AAR than the 5-year EM, even though it didn’t.
If you can’t articulate why a 15% AAR could be more desirable than a 25% IRR in certain situations, be very careful relying on the IRR number as a useful metric for you personally. As a long-term passive investor, I would rather enter a deal that is planning a 15% AAR over a 5-year hold compared to a deal that is planning a 25% IRR over a 2-year hold. My reasoning is that I’d rather do 1 deal that doubles my money in 5 years versus a deal that will give me a half of that return in less than half of the time but leave me searching for the next deal to find the other half.
5. Profit split
Make sure you understand how the profit split works. There are several different options for preferred or non-preferred returns and what’s known as profit “waterfalls.” Since this directly impacts what your distributions will look like over the life of the business plan, you want to make sure that you understand the investor split method so that it aligns with your goals and risk tolerance.
Some syndicators will offer a straight split like a 70/30, where 70% of the profits go to the investors and 30% to the syndicators.
Other syndicators will offer more complicated waterfalls that could look something like 70/30 up to 15% IRR, 60/40 up to 17% IRR, and 50/50 above 17% IRR.
Some syndicators will offer preferred returns like 8% pref and then 65/35, where 8% of the profits go to the investors before the syndicators get anything and once 8% is exceeded, the investors get 65% of the remaining profits and the syndicators get 35%.
Each of these methods offer pros and cons to the syndicator and investor, so the key here is to make sure you understand how it works and that the profit split seems reasonable for the deal you are considering.
Summary
There are other items to review and understand when considering investing in a passive real estate deal with a syndicator, but I hope you find these 5 tips helpful in getting started.
The best advice I can give is:
Aim to understand as much as you can and then ask questions directly to the syndicator before investing. If they are unable or unwilling to answer your questions, please think twice before investing with them.
At Regency Investment Group, our goal is to make sure that passive investing is right for you and that you understand the deal(s) that you invest in with us, after all, we are your partners in this!
*If you’d like to discuss this topic or anything related to investing in multifamily syndications, please reach out to me at Eric@regencyinvestmentgroup.com or click here to set up a meeting directly.
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