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Many investors are now putting their money into real estate, especially multifamily properties. There are a number of good reasons to do this. Prices for multifamily properties have skyrocketed over the past several years, and because of their limited availability and the fact that downsizing retired baby boomers are keeping vacancy rates low, prices will continue to rise.
If you’re a passive investor and want to start investing in real estate, the best way to do this is through syndication. Basically, a syndicator, or general partner, will form an entity (usually a limited liability corporation, or LLC) and then allocate shares in that entity to individual investors based on the amount each is investing. By investing with the syndicator, you’ll enjoy all of the tax benefits, income and potential appreciation without any of the hard work.
As with any investment, there are risks involved in a syndication. However, understanding those risks and ways to avoid them can make your real estate investment a safer one. Let’s take a look at some of the biggest risks along with ways to prevent them.
1. Losing Your Money
While losing your money is possible, it is unlikely. It would take a catastrophic event for passive investors to lose their money. The more likely scenario is that you won’t earn the returns that were outlined by the syndicator projected in your private placement memorandum (PPM).
Solution: Diversify your investments among different markets as well as different syndicators. Here’s why: If there were a recession, each market would be impacted in different ways. By spreading your investments across several markets, you will minimize your overall risks.
By investing with different syndicators, you will have the opportunity to participate in a variety of deals that have unique investment criteria. Limiting your investments to a single syndicator prevents you from seeing other opportunities that may be more advantageous to your investment goals.
Make sure you do your due diligence. Inquire about how experienced they are, whether they have managed to perform well and whether you share the same appetite for risk as they have. Some syndicators — like myself — are very conservative, and some are not. I advise looking for a syndicator who takes a conservative approach. It may be due to my background as a lawyer, but I’m conservative in nature. When I analyze a deal, I always plug in numbers that show the price will be lower than when it was purchased. If the deal still looks strong, then it’s a great deal.
One example that shows how conservative a syndicator is, is how the syndicator analyzes the exit cap versus in-place cap rate. That’s an important factor to look at before investing. Always ask the syndicator what cap rate they purchased the property at and what they’re predicting the exit cap rate to be. If you’re conservative, you want to invest in a deal where the exit cap rate is higher than the in-place or market cap rate. Finally, look at how the syndicator makes their occupancy assumptions. Stating that occupancy is at 97% of 100% isn’t conservative, and it isn’t reasonable.
2. Losing Your Passive Investor Protection
Passive investing means the investors don’t get involved in putting the deal together, finding other investors or managing the property in any way. If they do, they become active and lose their passive investor status.
A passive investor doesn’t have to have any knowledge or experience with real estate to invest in properties. That’s the role of the syndicator, or lead investor. The only real areas you shouldn’t be passive about are vetting the deal and the sponsor, and doing your due diligence on your investment.
The law protects you from bearing any responsibility on managing the property. You, personally, can’t be sued — the syndicator is the one who is exposed to that risk. However, you might lose that protection if you take an active role in managing the asset in any way.
Solution: Don’t take an active role in managing the property. Otherwise, you may find yourself with the same responsibilities as the general partner/syndicator.
3. Lack Of Transparency
There’s a reason investors pay syndicators fees when investing: so they don’t have to worry about any aspect of managing the property. Passive investors must feel comfortable with not controlling the deal, which is what a true passive investment is all about.
However, you want to feel comfortable with the person who is managing your money. If they don’t maintain proper communication, you won’t know what’s going on with your investment and won’t always know if it’s doing well.
Solution: Be sure you’re comfortable with the type of communication they offer. For instance, we provide monthly updates and share financial reports with our investors on a quarterly basis. Others do the same, and some share updates quarterly, semi-annually or sometimes annually. Some don’t submit any reports at all. I strongly believe that transparency is key and try to communicate with investors on a regular basis. If you’re comfortable with a yearly update, that’s fine, though I’d recommend investing with someone who is more communicative.
Summary
Avoiding the biggest risks in a syndication will provide you with peace of mind when you invest your money. The risk of losing all of your money is slim, but you may not earn the returns projected by the syndicator. Another risk is losing your passive investor status and legal protection, so never play an active role in managing the asset. Finally, avoid lack of transparency by talking with the syndicator before you invest, and have an understanding of how often and in what form they will keep you appraised of your investment. Eliminating these risks will make for a more successful investment.