Real estate syndications are often not only a great investment opportunity, but also a way to diversify your wealth portfolio. The right real estate deal can be a great addition for investing purposes and in many cases can have tremendous potential for growing your money. However, there are risks associated with every business or investment, and real estate syndication is no different. In this article, we will discuss some major syndication risks and possible ways to mitigate them.
You may want to exit your investment early
Sometimes emergencies and unexpected circumstances may force you to exit your investment early. This could be for many reasons such as changes in the market, your personal difficulties, problems with the property, etc. However, you should keep in mind that real estate syndications limit the ability to resell investor’s interest because they involve restricted securities.
Read your legal agreement with your deal sponsor to understand how you can sell your interest, when, and to whom. The sponsor might have the first right of refusal.
How to mitigate
Ensure that you have enough money in your personal emergency fund to cover your expenses in case of emergency. Remember that real estate in general is an illiquid investment, so diversify your portfolio to avoid challenges that happen when you have too much money invested in illiquid assets.
You may not earn the returns you expected
As a property brings rental income and its equity grows over time, a passive investor can count on income distribution. That is, investors get a preferred return on a monthly or quarterly basis that may constitute 5-10% of their initial investment annually. In addition, passive investors can benefit from remaining profits (if any) distributed between them and syndicators after paying all expenses. The sale of the property also involves a return on investment.
When attracting investors, sponsors outline the expected returns on participating in a real estate syndication. In reality, the returns may differ from the projected figures. While you are unlikely to lose all your funds invested, the lost profit can be very frustrating.
How to mitigate
To lower the risk of not earning the expected returns, get familiar with the business plan and documents related to the investment deal. You can request a so-called “pro forma” document containing projections and assumptions about the syndication project from a sponsor.
Another strategy is to spread your investments across different syndicators in different markets. This way, you can participate in real estate syndication with different investment criteria thereby lowering your risks of losing money. In addition, in the event of an economic downturn, different markets will react differently.
Property management may be underperforming
Day-to-day property management is an essential task assigned to either an in-house syndicator’s management team or a third-party management company. When property managers underperform, you may notice issues with vetting tenants or deferred maintenance and repair requests. As a result, an eviction rate grows while the occupancy rate declines. Even worse, property managers may misbehave by overbilling their work or stealing materials.
Poor property management makes it difficult to raise rents to a level that is beneficial to investors, thereby lowering the net operating income.
How to mitigate
Before investing in a real estate syndication project, make sure a sponsor screens the prospective property managers thoroughly. Experienced sponsors typically gather referrals from industry peers and vet candidates by conducting interviews and visiting select properties managed by them.
Taking an active role in property management may result in losing your passive investor status
One of the greatest things about passive investing in real estate is staying hands-off from property management. Besides doing due diligence on your investment deal and the syndicator, you don’t have to be an expert in real estate.
Sometimes passive investors want more engagement and control in a syndication deal. If you as an investor want to switch from a passive to an active role, beware of the potential liability for an entity‘s financial obligations.
How to mitigate
The advice for mitigating the risk mentioned above is pretty straightforward — don’t take an active role in property management. If you do, you will lose your passive investor status protecting you from liabilities that syndicators have.
Market conditions may not be in your favor
Market conditions surrounding properties your syndication invests in have a significant impact on the financial success of the deal. Multifamily syndication deals relying on assets located in regions with only one industry are at risk in case the industry falls. Employment issues and decreased income could result in growing vacancy rates forcing homeowners to lower their rents.
High crime rates in certain areas are another deterrent to an increasing influx of tenants that lowers an investor’s return.
How to mitigate
To lower the market risks, assess the location of an asset that your real estate syndication is putting funds in. Opt for locations with diverse employment opportunities, high median household income, and low crime rates.
Sponsors may fail to raise rents as expected
To ensure cash flow growth in multifamily syndications, general partners typically rely on raising rents. To make projections on the possible rent raise, sponsors look at similar assets. Once a syndicator has an idea of the potential rent growth in comparable properties, they can assume how much they can increase their cash flow. But, actual figures may differ from those outlined in the private placement memorandum. If sponsors are not familiar with the region of assets they are investing in, these differences will most likely be not in your favor.
How to mitigate
To lower the risk of inaccurate rent raise projections, make sure a sponsor has already made investments in a given location. Knowledge of the city and its average rents is key to accurate estimates of the expected rent increases.
The value add strategy may take longer than expected
Commercial real estate investing often involves a value add strategy. This strategy assumes the growth of cash flow and a property’s appreciation over time. To make this happen, sponsors initiate property improvements and increase rents.
When making business plans, sponsors estimate the timeframe for a value add strategy execution. Still, the actual timeframe could be longer than expected. In the most unwanted scenario, longer than the financing term for a leveraged property is.
How to mitigate
To mitigate the risk of a prolonged value add strategy, check if your syndicator has implemented such strategies before. Another thing to look at in real estate syndications is the contingency reserves the investment company has. With adequate reserve funds, the company will cope with unforeseen circumstances.
There might be troubles with generating the desired return when investing in highly-leveraged properties
Real estate syndications typically use leverage to buy a real estate asset. A challenging task for a sponsor here is to make sure that the property’s cash flow will cover the debt. Therefore, an asset with a higher debt-to-equity or loan-to-value (LTV) ratio could become a risky investment. Market downturns can wipe out the equity as a real estate property is losing its value. As a result, a sponsor will have to raise additional capital or use reserves, if any.
How to mitigate
To prevent such a situation, be sure to look at the debt portion used in a real estate investment deal. Value-add real estate syndications with a loan-to-value ratio of 80% and above will expose you to higher risks in case of market downturns. If you are an aspiring passive investor, starting with deals having 60-70% LTV will be safer for you.
Delays in the supply of materials and labor can shift the expected value add timeframe
Many investors rely on the expected value add timeframes specified in a private placement memorandum. Say, you passively invest in a deal that involves the construction and expect a project to bring rental income in 18 months. Issues with materials and contractors will shift the value add timeline, resulting in cost overruns.
How to mitigate
To lower the risks of delays, check with a sponsor how they handle such situations. As an investor, strive to work with an operator that has established partnerships with local contractors.
State and local government legislation may influence your cash flow
Investing in real estate syndications may sometimes involve legislative constraints putting your expected returns at risk. For example, passive investors in Section 8 housing can count on subsidies for the rental income portion. Changes in the current legislation may negatively impact the financial outcomes of a deal.
Cash flow generated through short-term rentals is also subject to local legislative risks as governments often limit such opportunities.
How to mitigate
To avoid legislative constraints, make sure a sponsor has an experienced legal team on staff. These specialists will track all legislative changes on time so that an operator can take the necessary measures.
Investment deals in certain geographic areas may involve environmental risks
Certain geographic areas are at risk from hurricanes, floods, and other natural disasters. Since these events are force majeure, it can be extremely difficult to recover the financial losses caused by them.
How to mitigate
The most straightforward recommendation for preventing environmental risks is not to invest in a real estate deal in high-risk areas. If you are still willing to invest, make sure a sponsor has purchased the appropriate insurance coverage. In addition, a lender issuing a mortgage for a property will most likely require a sponsor to buy an insurance policy.
Final notes
As you can see, there is a range of risks to keep in mind when investing in syndications. Knowing the potential pitfalls will help you in your due diligence process and make the most out of your wealth-building strategy.
