4 Factors to Consider when Evaluating a Real Estate Syndication Investment
We all know that investing in real estate provides great benefits but what happens when the income from your rental property is eaten up by vacancies, repairs or even theft? Not to mention, the amount of time you spend having to deal with these issues. Unfortunately, these are common headaches when owning and managing a rental property yourself which is why many experienced investors prefer investing in multi-family real estate syndications. Let’s review the top reasons why.
Investors love real estate syndications because they provide access to no-hassle, hands-off real estate investing. While it’s true that syndication investments offer great benefits and are completely passive, it is imperative that investors put in the time and effort upfront to choose the best opportunity. Like every other investment, the risk and reward of a syndication can vary greatly from deal to deal. So how do you determine which is the best investment for you? While there are many details to consider during due diligence (we can help with that when you get there!), there are 4 key factors that should be evaluated for each syndication:
1. The Market
Location, location, location. You hear it all the time in real estate, but what does it mean? When looking at a property’s potential to increase in value, there may be no bigger factor than a strong market. At the end of the day, this boils down to one thing: does the market support demand for housing that will not only provide strong occupancy rates, but also produce rent growths. A market analysis should include two areas: a full overview of the market as well as key real estate drivers.
An overview of the market should indicate the current state of the local economy, as well as the potential for future growth. Two indicators of this are job growth and population growth, which typically work in tandem. Is the area business friendly, ensuring new businesses and reliable jobs will continue to come to the area? Has residency continued to increase as more jobs have become available? Does the market support a high quality of life including education, entertainment, healthcare, transportation, etc?
Another metric to review is the diversity of industries that drive the economy. Is the market dependent on the state of a single industry, or is it spread across a wide variety such as IT, Healthcare, Manufacturing, telecommunications, etc? It is considered a good rule of thumb to have no single employer in the area employing over 20% of the population.
Once you feel confident about the overall state of the market, you need to dive deeper into the real estate drivers as well. Are rent increases outpacing the rest of the country? Do rental properties have the ability to cash flow and appreciate, while also being affordable? Are most of the housing units occupied by owners, or does the growing population tend to occupy rentals? All of these factors go into evaluating a particular real estate market’s long-term growth potential.
2. The Sponsor
Every syndication has a sponsor, or operator, that is responsible for finding the deal, putting together the business plan, and executing the day to day operations. While investors make up the limited partners of the syndication, and have the benefit of being hands-off, it is critical to ensure that the sponsors responsible for the active management are fully vetted.
The most important area to review is the sponsor's track record. What are their total assets under management, and how do the actual returns compare to their projections? How many business plans have they completed, from acquisition to sale, and what are the average rates of return? It is also important to look at the property being evaluated compared to their prior experience. Is this property located in an area they typically focus on, or is this a new market they are expanding to? Is the property similar to others they have experience with, such as the size, class and current condition?
In addition to the actual sponsors, it is also good to look at the team that will be assisting them. CPA’s, contractors, and property management personnel are a few examples of roles that are needed to successfully manage the property and overall investment. It is just as important to review these team members in addition to the sponsor, to ensure their experience aligns with the syndication deal at hand.
3. The Business Plan
You’ve identified a handful of markets to focus your portfolio on, have vetted a few sponsors to review deals from, and are starting to receive a number of opportunities, so now what? How do you pick the right syndication to invest your capital? This is when you need to dive into the business plan to determine the risk profile and potential returns. The great news is that the sponsors have already performed an exorbitant amount of due diligence as part of the underwriting and acquisition process. Investors should focus on reviewing all of this information and analysis to ensure there are no red flags, and that all assumptions make sense.
Investors need to ensure that the business plan is structured in a way to protect their capital. Is the property being purchased at a discount from the market Cap Rate? Are the terms of the debt financing beneficial to the hold period (i.e. interest only), and is there an opportunity to refinance to return investor capital if needed? Does the capital expenditure budget include sufficient contingencies?
Determining if a syndication asset can produce positive cash flow and increased equity growth comes down to two opportunities: value-add updates and operational efficiencies. Is there an opportunity to add amenities to the property that renters will pay a premium for, such as a fitness center, dog park, etc? Does the market demand updated kitchens, modern fixtures, in unit washers and dryers, etc? Does the property exterior need a refreshed look or rebranding?
While properties will almost always need updates, they are oftentimes poorly managed as well. Is there a marketing budget and plan to keep a strong flow of new tenants. Are rents currently below the market value? Is there an onsite maintenance team and budget to keep the property in great shape?
When looking at multiple opportunities and business plans, you not only want to compare the projected cash flow and equity returns, but you also want to look at how conversative the financial analysis is. Are the projected rent growth and occupancy numbers in line with the rest of the market? Do the capital expenditures and expected operating expenses make sense? How low can the occupancy be while still breaking even? These all contribute to the net operating income of the property.
What is the exit strategy, and are there multiple options (i.e. refinance or sell) based on market conditions? Is the projected exit cap rate conservative based on the market? These will contribute to the overall value of the property and equity growth. Perhaps the most important part of an investor's due diligence is understanding the assumptions the sponsors are making when they present these projections.
4. The Terms
You’re now in the home stretch. After reviewing the details of the business plan, you feel confident that the investment is low risk and that there is a great potential upside. So what does this all mean for your passive investment? The final step is reviewing the terms of the investment, and ensuring that it aligns with your investment goals while you kick back and relax.
Cash Flow Distributions
As the business plan is fully operational, the positive cash flow will be paid to investors. A couple of things you should be aware of is the timing, the preferred return amount, and the projections per year.
Are the distributions paid on a quarterly basis, or monthly? The preferred return is the cash flow an investor will receive per year prior to the general partners receiving any distribution. This is typically cumulative, meaning if one year comes in lower, there will be a catchup so that the average over the life of the investment meets the target.
Preferred returns typically range from 7-10% (i.e. a $100K investment should produce $7-10K of cash flow per year). Is the property expected to hit the preferred return in year one, or will the returns be lower for the first year or two?
How are your sponsors going to work to reduce the taxable income from the real estate investment? Tax deductions are a huge benefit to direct ownership in real estate, which is how syndications are structured, and the reason many investors take part in syndication versus other types of investments. Investors receive tax-efficient (often tax-free) income due to write-offs for depreciation, mortgage interest, repairs and other property expenses, etc.
When the property is sold, the net profits are typically split up between the sponsors (General Partners) and investors (Limited Partners). Common splits include 70/30 or 80/20 LP to GP. This will be key in evaluating the overall return of your investment (equity multiple), and how long it will take to get there (Internal Rate of Return). Many syndications also offer different classes of investment. Class A usually offers a higher preferred return with no profit split, while Class B offers a slightly lower preferred return as profit split. It is important to evaluate these options to meet your investment goals, whether the primary objective is steady income or long-term growth.
The last set of terms to review is the waterfall. This defines the order in which both cash flow and equity are paid out. When it comes to cash flow, investors get paid first up to their cumulative preferred return, and then will split the remainder with the sponsors (i.e. 70/30).
When it comes to the sale or refinance of the property, it is common for investors to get paid their full initial investment, and then split the remainder of the profits with the sponsors (i.e. 70/30). For both of these cases, there is usually a threshold that determines a different split (i.e. once investors receive 2x their investment, the split becomes 50/50). Understanding the waterfall of cash flow and equity is key to ensuring your investment is protected and is capable of meeting your goals.
Once you make an investment in a real estate syndication, your job is done. But investors want to make sure that their passive investment is performing as expected, providing the cash flow and overall returns to meet their investment goals. That is why it is imperative to put the time in upfront, and consider the 4 factors defined above. If all of this due diligence sounds overwhelming, don’t worry, this is exactly where our company can help! If you’re ready to start exploring investing in no-hassle, hands-off real estate syndications definitely reach out!
If you’re interested in learning more about investing in a real estate syndication, download your free copy of our eBook, Achieving Financial Freedom by Investing in No-Hassle, Hands-Off Real Estate.