Is investing in a syndication risky if the market changes?

23 Replies

Is investing in a syndication risky if the market changes?  I don't want to invest money for years in an apartment deal if there is a chance the market could change and leave the syndicator broke.  Any suggestions on this?

As long as you invest with a solid operator the risk would be that your returns are a bit lower than projected and/or a longer hold time to allow the market to improve.

I have little concern over the syndicated investments that my colleagues and I invest in because we perform proper due diligence on the sponsor, location, purchase price, cash flow, debt, value add, exit price, and other underwriting assumptions.  On the flip side of the coin, we see tons of offerings that we pass on.

There is risk in everything. Finding sponsors that can change their operating procedures without going over the cliff should market conditions change is key. Many of the deals we look at seem to have some pretty rosy assumptions 3~5years out. What happens if the storm clouds move in and all the predictions made in years past said only sunny weather? What's their game plan? I have looked at apartment deals here without any mention of rent control. Rents are assumed to just keep going up until this huge refi takes place and we all get our capital returned. No mention at all about how they would adjust their financial and operating model should these activists get their way - and they are a growing lot, a take no prisoners virulent group, very loud, and they want things to change. Yet many sponsors make no mention of this. Sponsors and investors that recognize that social and cultural conditions could also negatively affect their assumed 30% IRR would have a better chance of survival if and when the apartment bear market arrives.

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My favorite phrase - "Compared to what?"

Is there market risk? Absolutely. We only buy properties that can weather economic storms, based on underwriting stress testing. That's a mix of falling market rents, lowered occupancy, higher cap rates at sale, increased expenses, and other conditions like that.

There's always a chance any investment could go south due to changes in the market. As long as we can keep some positive cash flow and not have to refinance during unfavorable debt market conditions, we should be able to ride out market crashes.

@Brian Burke usually has some awesome thoughts on this topic

@Josh Rogers

Walking on the streets could be risky as well as one can be hit by a car! So, yes of course investing in syndications is risky. But as @Mike Dymski elegantly put it, if you do proper due diligence (DD) and evaluate (a) the deal sponsor, (b) the market, and (c) the overall offering itself, and all of it fits your preset criteria, then you're making your decision to invest based on the calculated risk. 

I think the most critical components to smart investing is to:

1) educate yourself on the syndication process

2) educate yourself on the asset classes

3) network and do the research to find the sponsor(s) to work with

4) read up on the DD to determine whether an offering works for you

Here're some blog posts to help you further your education:

https://www.biggerpockets.com/member-blogs/10850/84504-step-by-step-process-on-how-to-invest-in-a-real-estate-syndication

https://www.biggerpockets.com/member-blogs/10850/79257-deciphering-syndication-investment-terminology

https://www.biggerpockets.com/member-blogs/10850/78500-is-your-portfolio-at-risk-if-the-market-crashes

https://www.biggerpockets.com/member-blogs/10850/76728-questions-to-ask-a-syndicator

@Josh Rogers Don't invest at all then. There is always risk including leaving money in savings account or in a safe. When money is not invested it loses it spending power due to inflation. There is no way that an investor can know 100 percent that a deal will not fail. If you want lower risk invest in a higher quality asset but keep in mind often your return is a measure of the risk.

Originally posted by @Josh Rogers :

 if there is a chance the market could change and leave the syndicator broke.  Any suggestions on this?

I think the best advice to stack the deck in your favor is to invest only with syndicators that aren't on the precipice of "broke-ness."  Look for groups that have been through adverse cycles before and lived to tell about it.  Depending on the depth of an adverse cycle, everyone will get hurt.  Some will survive.  Some will thrive.  And some will dive.  

This is a bit like trying to figure out which overturned cup is hiding the marble, but proper due diligence on the sponsor, with the awareness that the sponsor can make or break the deal, can give you the best odds of the most favorable outcome. 

"Is investing in a syndication risky if the market changes? I don't want to invest money for years in an apartment deal if there is a chance the market could change and leave the syndicator broke. Any suggestions on this?"

There is definitely risk. That is why all PPMs say the investor should be prepared to lose all their principal before signing.

I am sure you know we are in the late stage of the RE cycle. The economy is arguably overdue for a correction. While multi-res was found relatively recession resistant during the last great recession, it does not mean it will be the case the next time given all the building that has been going on. While homeownership is still a challenge for many, I can also see that in the next downturn, because of the recent increases in rents, renters may start doubling up and sharing rooms.

If rents dropped enough or vacancies rose enough so than the property's income could not service the debt, the lender could call for repayment and that would be the beginning of the end for the investors investment.

My suggestion at this point in the cycle is to find sponsors that have been through the last recession and projects that are conservatively leveraged. Less leverage usually implies lower returns but it also provides a greater margin against market forces, the impact of which the even best sponsors may be challenged to navigate through.

@Josh Rogers

You are a college student bro. You should not think about being a LP until you have at least 200-500K net worth.

Go out and do your own deals or just buy a turnkey rental.

@Josh Rogers I think investing in syndication can be quite risky for several reasons.

1. You have zero say or control. If you do poor research or underwriting, you could lose all your investment

2. It’s a highly illiquid investment. You don’t get that money back for 5-7 years if you’re lucky. I’ve seen some syndication deals with a ten year hold. That’s insane.

Syndication is a good way to invest but you are better off doing your own deals first. Returns are generally better and you have more control. You’ll learn a lot more too. Then when you are worth 500-1M or are an accredited investor you can throw 25-50k into a syndication and see what happens.

Originally posted by @Caleb Heimsoth :

@Josh Rogers I think investing in syndication can be quite risky for several reasons.

1. You have zero say or control. If you do poor research or underwriting, you could lose all your investment

2. It’s a highly illiquid investment. You don’t get that money back for 5-7 years if you’re lucky. I’ve seen some syndication deals with a ten year hold. That’s insane.

Syndication is a good way to invest but you are better off doing your own deals first. Returns are generally better and you have more control. You’ll learn a lot more too. Then when you are worth 500-1M or are an accredited investor you can throw 25-50k into a syndication and see what happens.

Hey Caleb.  I am normally aligned with your thoughts but we may be misaligned on this one.

Offering packages may say 5 or more years for conservative purposes but many have plans to sell or refinance (supplemental loan) after the value add to realize the sponsor compensation on the sale, eliminate/reduce the preferred return, and to maximize IRR and increase the velocity of capital. I do agree that some are intended longer term holds (which some passive investors actually prefer).

Most investors are not better off doing their own deals first and will not make more money on their own.  Investors CAN do both of those but most don't.  We get a biased view based on what we see on BP and what we can do but that is a small fraction of the population.  Sourcing and managing a direct owned portfolio is a lot of work and not interesting to most people.

Well like anything in REI you have to evaluate the syndicator and the particular deal. Stress test: what are they doing to mitigate risk during a downturn? One reason, I like deals that don't use leverage and have the flexibility to weather a storm in the economy.

Originally posted by @Mike Dymski :
Originally posted by @Caleb Heimsoth:

@Josh Rogers I think investing in syndication can be quite risky for several reasons.

1. You have zero say or control. If you do poor research or underwriting, you could lose all your investment

2. It’s a highly illiquid investment. You don’t get that money back for 5-7 years if you’re lucky. I’ve seen some syndication deals with a ten year hold. That’s insane.

Syndication is a good way to invest but you are better off doing your own deals first. Returns are generally better and you have more control. You’ll learn a lot more too. Then when you are worth 500-1M or are an accredited investor you can throw 25-50k into a syndication and see what happens.

Hey Caleb.  I am normally aligned with your thoughts but we may be misaligned on this one.

Offering packages may say 5 or more years for conservative purposes but many have plans to sell or refinance (supplemental loan) after the value add to realize the sponsor compensation on the sale, eliminate/reduce the preferred return, and to maximize IRR and increase the velocity of capital. I do agree that some are intended longer term holds (which some passive investors actually prefer).

Most investors are not better off doing their own deals first and will not make more money on their own.  Investors CAN do both of those but most don't.  We get a biased view based on what we see on BP and what we can do but that is a small fraction of the population.  Sourcing and managing a direct owned portfolio is a lot of work and not interesting to most people.

I agree with your points.  I think syndications are great and hope to participate in them myself someday.  

My main point in my previous post was to outline some of the risks with syndication to the OP.

Originally posted by @Josh Rogers :

Is investing in a syndication risky if the market changes?  I don't want to invest money for years in an apartment deal if there is a chance the market could change and leave the syndicator broke.  Any suggestions on this?

 Josh, that's a great question that you're asking. And anyone who is mocking you for asking (or implying that you have too little experience to be in the position to ask the question) is either kidding themselves or out of line, in my opinion.

The answer is absolutely yes, there is market cycle risk with any real estate investment. And I believe that anyone who denies it is kidding themselves. Do I believe that this means every sponsor is going to go bankrupt in the next recession? Again anything is possible, but personally I think it's very unlikely.

If you take a look at virtually every syndication pro forma, you will almost never ever see projections based on even a small recession, let alone a severe one. Instead you will see steady growth projected forward for the next 5 to 10 years (however long the investment is projected to run). Is that the most realistic or likely scenario? Arguably not. It would be great if that ends up happening anything is possible. But as a conservative investor, I don't count on it.

So what I do is a severe recession stress test on every investment. I get the vacancy and rental drops through the last couple of recessions (since each recession is different and often the last recession was not the worst for multifamily) for that particular area, and then apply them to the weakest year in the pro forma. If I can't live with the result that I don't invest.

The other thing I do is at the stage of the real estate cycle in a mainstream asset class like multifamily, I require that the sponsor have full real estate cycle experience with no investor money lost. I personally don't want a sponsor who is never experienced adverse economic conditions learning very expensive mistakes with my money. Make sure to ask for the complete track record, including the unrealized deals, sometimes this is where the dogs are hidden (and some sponsors don't release this information without extra effort).

Originally posted by @Josh Rogers :

Is investing in a syndication risky if the market changes?  I don't want to invest money for years in an apartment deal if there is a chance the market could change and leave the syndicator broke.  Any suggestions on this?

 Its more risky to hold cash and do nothing.

Originally posted by @Mike Dymski :
Originally posted by @Caleb Heimsoth:

@Josh Rogers I think investing in syndication can be quite risky for several reasons.

1. You have zero say or control. If you do poor research or underwriting, you could lose all your investment

2. It’s a highly illiquid investment. You don’t get that money back for 5-7 years if you’re lucky. I’ve seen some syndication deals with a ten year hold. That’s insane.

Syndication is a good way to invest but you are better off doing your own deals first. Returns are generally better and you have more control. You’ll learn a lot more too. Then when you are worth 500-1M or are an accredited investor you can throw 25-50k into a syndication and see what happens.

Hey Caleb.  I am normally aligned with your thoughts but we may be misaligned on this one.

Offering packages may say 5 or more years for conservative purposes but many have plans to sell or refinance (supplemental loan) after the value add to realize the sponsor compensation on the sale, eliminate/reduce the preferred return, and to maximize IRR and increase the velocity of capital. I do agree that some are intended longer term holds (which some passive investors actually prefer).

Most investors are not better off doing their own deals first and will not make more money on their own.  Investors CAN do both of those but most don't.  We get a biased view based on what we see on BP and what we can do but that is a small fraction of the population.  Sourcing and managing a direct owned portfolio is a lot of work and not interesting to most people.

 Totally agree. I am beginning to realize that 100% of a 25% annual return isn't worth it to me over 70% of a 20% annual return. In the former, this is tons more time and headache up front, dealing with tenants, lenders, repairmen, and property managers, etc. All for what? I'd rather take half the capital gain in exchange for no headaches and hundreds of hours freed up over the course of the investment. I can always make more money, I can't get back the time I spend managing an active deal (which often isn't fun nor intellectually stimulating).

That's why a passive investor should always perform their own due diligence on the deal, the team, and the market before investing.

For the deal, you want to review their underwriting assumptions (debt, rents, annual income and expense increases, etc.).

For the team, you want to review their track record of successfully taking deals full cycle

For the market, you want to review the fundamentals (population growth, job growth, job diversity, median income to median rent ratio, etc.)

Love that your exploring this at such a young age. 

If and when you are ready to invest in a syndication, you would have properly vetted out the sponsor. You also would have the flexible capital to dive in and most likely with the minimum investment. Going through the decision making would come with the understanding that there is risk of losing it all. Like everything in live with risk comes reward and with rewards comes risks. 

Originally posted by @Josh Rogers :

Is investing in a syndication risky if the market changes?  I don't want to invest money for years in an apartment deal if there is a chance the market could change and leave the syndicator broke.  Any suggestions on this?

Yes - it is risky to invest in syndication if the market goes down. It's also risky to invest outside of syndication if the market goes down. So, if you don't do one, because it's risky, and you don't do the other, because it's also risky, then all that's left is to do nothing... am I missing something?

Investing is inherently risky - period. Run away if someone tells you otherwise.

That said, I think you need to look at redundancy. For example, the lender may only require $225,000 in reserves on a $20MM acquisition. However, is that really enough... 

How about doubling that? How about tripling that? 

How about raising $1MM in addition to what the lender requires, to cover CapEx reserves for major mechanicals, cost overruns, and working capital. How about raising all of that at the beginning of the deal so you can take the hits later on?

Of course it better be a really good deal in this case, because with so much extra capital raised it get's difficult to underwrite returns...

In other words, I won't lie - as a sponsor, it would be very difficult, likely impossible for me to carry a $20MM deal gone bad. I think this is a true statement for most. For this reason, I raise A LOT of reserve money and price it into the deal. If I can't afford a good cushion, the deal is not good enough.

Hope this helps.

@Josh Rogers

Lots of good comments here. Short answer is that it's always risky. 

With a good operator, you could end up with better diversification and lower correlation for a future crisis. With a bad operator, you're taking a big risk, anyway.

Depends on the asset class. Multifamily had a 0.4% default rate in the last recession, so it is generally considered less risky compared to other types of commercial real estate. Besides complete loss of principal, there is risk that returns are lower than projected.

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