SS188: Real Estate Syndication Red Flags

SS188: Real Estate Syndication Red Flags

Successful passive investing requires investors to be very mindful of the deal and the sponsor. In this episode, Charles discusses some red flags of real estate syndication.

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Talking Points:

  • Regular listeners to the show will already know that I am an active multifamily investor, but I am also a passive real estate investor, investing passively in my first real estate syndication in 2018.
    • Over the years, I have invested in dozens of properties, with some of those deals going full-cycle, meaning they were repositioned and sold. A couple of years back, I began recording my investment philosophy, how much I will allocate to certain investments, general guidelines, and red flags.
    • The idea for this specific episode comes from a recent passive investment of mine, in which the sponsor became overwhelmed and literally vanished. I was lucky enough to recoup my investment for the specific deal I invested in, but I dedicated dozens of hours of my time to this over the past year, and I was one of the lucky investors since most passive investors in this sponsor’s other deals lost their investment.
  • Let’s go through some of my investment criteria and red flags for deals and sponsors. These are specifically for passive real estate investments, with some of the guidelines geared more precisely to multifamily properties. No matter what you are passively investing in, however, these should hopefully assist you with becoming a better investor.
    • I do not want to get into the details of choosing markets; you can listen to episodes SS1 and SS2 for that. You can also listen to SS117 to learn how to minimize risks when investing passively in real estate syndications.
    • Before investing in anything, I believe it is always important to have some investment philosophy; it doesn’t need to be in-depth to start but documents that you can regularly review, edit, and adjust throughout your investing career.
      • To start off, you might have different percentages of your net worth allocated to different asset classes, and there is a limit on the amount you can invest in any asset class, individual property, or fund. For example, you will not invest more than 5% of your net worth in any individual value-add passive real estate investment. Maybe you will not invest more than 3% in any individual construction passive real estate investment, since they are typically riskier. I had a mentor years back who touted 5% as always being the most you should invest of your net worth in any specific investment, which is a great general guideline. I would lower this even more for higher-risk investments. Setting these guidelines now; will make you rethink any future investment where you might be letting your greed get in the way.
    • Once you have set some guidelines, I will start at a high level with the sponsor. We start with the sponsor since you should be reviewing sponsors way before you invest with them; this way, you are not reviewing them while at the same time reviewing a deal that they are closing on in 2 weeks.
      • First, the size of the sponsor’s team. Sponsors with large teams usually need to transact since they typically fund their payroll, office, etc., with acquisition fees, and not every deal they do might be a good deal. With this being said, I have invested in sponsors with big teams, with mixed results, and only one of these I would reinvest in again. My best experiences have been with small operators who only do a few deals yearly.
      • Next, the investing experience of the operators. I want to invest with operators who have been active investors in the asset class for at least 15 years. Not every person needs to have that experience, but the actual deal operators need to be well-experienced.
      • In addition, I want the operators to have at least 5 years of experience as syndicators. When you syndicate properties, you are now managing properties and investors. This takes more time, more people, more transparency, etc.
      • I want to see that at least one operating partner is unrelated. If there is an issue, especially a family issue, you want to know that there is someone there who can take over operations. This also means that I like to see at least 2 operating partners.
      • I like operators primarily focused on one 1, maybe 2 markets. If you are investing with a general partner or a capital raiser, I want to see that they work mainly with 2-3 deal operators. Seeing that they are doing their 5th or more deal with an operator shows their relationship and trust with the operator.
      • I do not invest with any specific sponsor more than once yearly.
      • I want to confirm that the deal operators are full-time investors; I do not want to see a team of deal operators who are part-time syndicators.
      • I also do not emphasize sponsors with higher education qualifications. Going to school and obtaining an MBA versus starting a successful business and continually making payroll through the ups and downs are 2 very different things.
    • Going further, what are some deal-specific red flags?
      • First, deals with no preferred returns. I want to ensure that I receive a reasonable return before sharing the returns with the operators. Typical preferred returns are usually between 6% and 8%.
      • The second red flag would be an operator’s first deal with the property management company. I do not want to see the manager change during my investment hold time. They should already have a current business relationship with the property management company.
      • Furthermore, I do not want to be an operator’s first deal in a new market; I really want to be like their 5th deal in the current market with their current property management company. How close are their other deals to the subject property? The closer, the better, for a couple of reasons. First, the property will not be overlooked during the property management and asset management visits. They most likely will be able to utilize the same general contractors on the new property as they do with their current properties. If their other properties are nearby, they will know the market better than most; usually giving them an advantage over other operators while hopefully making their underwriting more accurate.
      • Another potential red flag is operators that model a refinance in the return projections. The further down the road, the less accurate the underwriting model. I always like to remove the refinancing event and see how the returns will differ.
      • Verify that distributions are return ON capital instead of return OF capital.
      • How much are the sponsors contributing to the deal? I would like to see the deal operators provide about 20% of the capital raised. Also, ensuring that the operators are financially sound is important. If the deal requires more capital during the hold period, most general partners will provide a 0% loan to bridge any temporary cashflow restraints. On our first syndication, our lender was dragging their feet on the construction draws during the renovation, so the general partners put in an additional $100k as a 0% loan to ensure we could continue renovating units at the pace we were going.
      • What is the business plan? Some operators like to promote a deal by saying that it has been recently renovated, and that is great for some investors, but that is not really a value-add deal. That is more of a yield play deal. For value-add deals, I really want to see a pathway for rents to be increased at least 20%- 25% after renovation. If rents are currently $1,500, I want to see comparable, renovated units renting for $1,900 or more.
      • Income can be estimated pretty easily; you can look at the trailing 12 months and see what has been collected, but what about expenses? Most notably, property taxes and insurance. How are they coming up with these numbers, and what are they estimating for annual increases for these 2-line items?
      • What type of debt is being obtained? Floating rate debt is not a wrong choice if the deal is a heavy value-add deal with a lot of potential if the work is executed correctly. These are deals where you are seeing current rents at the property being 30%- 40% or more under the market. Units haven’t been updated in decades, and there is deferred maintenance; this is where massive value can be added in a rather short amount of time. The issue with floating rate debt is that some sponsors use it for deals with minimal upside. Deals with minimal upside are more yield play deals, and operators should use long-term fixed-rate debt.
      • Lastly, always confirm bank wire transfer details by calling the sponsor before wiring funds, having the sponsor read back the wire transfer details to you on the phone, and then emailing them right after wiring the funds to confirm receipt. US wires should only take about 1 business hour to be received.

 

By being a diligent passive investor, you can better protect your investment capital. There is no right or wrong way of passively investing, but make sure that the deals you are investing in have enough meat on the bone.

Transcript:

Charles:
Welcome to Strategy Saturday; I’m Charles Carillo, and today we’re going to be discussing real estate syndication red flags.

Charles:
So regular listeners to the show will already know that I’m an active multi-family investor, but I’m also a passive real estate investor, investing passively in my first real estate syndication in 2018. Now, over the years, I’ve invested in dozens of properties with some of those deals going full cycle, meaning that they were repositioned and sold. And a couple of years back I began recording my investment philosophy, how much I’ll allocate to certain investments, general guidelines, and red flags. The idea for this specific episode comes from a recent passive investment of mine in which the sponsor became overwhelmed and literally vanished. I was lucky enough to recoup my investment for the specific deal I invested in, but I dedicated dozens of hours of my time over the past year, and I was one of the lucky investors since the most passive investments and the sponsors other deals lost their investment.

Charles:
Now let’s go through some of my investment criteria in red flags for deals and sponsors. And these are specifically for passive real estate investments with some of the guidelines geared more precisely to multifamily properties, no matter what you’re passively investing in. However, these should hopefully assist you with becoming a better investor. Now, I do not want to get into the details of choosing markets. You can listen episodes, SS one and SS two for them. You can also listen to episode SS 107 to learn how to minimize risks when investing passively in real estate syndications. So before investing in anything, I believe it’s always important to have some investment philosophy. It doesn’t need to be an in-depth report to start, but document that you can regularly review, edit, and adjust throughout your investing career. Now, to start off, you might have different percentages of your net worth allocated to different asset classes, and there’s a limit on the amount you can invest in any asset class, individual property or fund.

Charles:
For example, you’ll not invest more than 5% of your net worth in any individual value add passive real estate investment. Maybe you’ll not invest more than 3% in any individual construction, passive real estate investment, since they’re typically riskier and I had a mentor years back who tell it 5% as being the most you should invest of your net worth in any specific investment, which is a great general guideline, I would lower this even more for higher risk investments. Setting these guidelines now will make you rethink any future investment where you might be letting a greed get in the way. So once you have some guidelines, I would start at a high level with a sponsor. You know, we start with a sponsor. You should be reviewing the sponsors way before you invest with them. This way you’re not reviewing them while at the same time reviewing a deal that is closing in two weeks and you have to fund in two weeks while making a decision.

Charles:
Now, first is one of the things I look at is the size of the sponsors team. Now sponsors with large teams, and this doesn’t include property management, right? We’re talking just the syndication portion of it, right, where they’re kind of overseeing doing asset management raising money, finding deals, stuff like this. Now first, the sponsors team. Now sponsors with large teams usually need to transact since they’re typically funding their payroll, their office expenses with acquisition fees, and not every deal they do might be a good deal if they have to close one to get that acquisition fee to keep their lights on. You don’t wanna be an investor in that deal, right? With this being said, I’ve invested sponsors with big teams with mixed results, and only one of these I would reinvest in. Again, my best experiences have been with small operators who only do a few deals yearly, usually one or two.

Charles:
Now next, the investing experience of the operators. Now I want to invest with operators who have been active investors in the asset class for at least 15 years. Not every person needs to have that level of experience, but the actual deal operators need to be well experienced. In addition, I want the operators to have at least five years of experience as syndicators. When you syndicate properties, you are now managing properties and investors, and this takes more time, more people, more transparency, et cetera. So one thing I’ve found when I’ve ever spoken to family offices is that if you don’t have a long enough track record, they’ll tell you, Hey, come back in five years. This sounds great, what you’re doing come back in five years. And that is their filter, right? They can get rid of a, I imagine a very high percentage of people to not bother them if they know, hey, you’ve gotta be have this has to be, you have to do this for so many years.

Charles:
You’re gonna have this track record, you have this, and once those line up, then they speak to you. And I think it’s important to have that for yourself as well. I don’t wanna be talking to someone that’s just getting into an asset class a few years ago. I want someone that’s been through the ups and downs with their asset class. Being an investor that went through oh 7, 0 8, 0 9 it’s something that you learn a lot going through times tough times. So it’s one of those things where anything that you have, you wanna make sure that that person is well experienced in that asset class. And then also something that’s well experienced I would say five years as a syndicator. Because the thing is that you find some syndicators that might have that 15 plus years of experience, say as a multifamily operator, however, you kind of know that maybe they’re not the most seasoned syndicators because they might not have the best communication with you.

Charles:
They might not be as open with transparency. And I think when you find operators that have been around for five or more years, they’re used to people asking questions. They’re used to taking the time and working with new investors and educating them and explaining to them exactly what they do, whereas maybe an older investor goes, I, I don’t need this and I don’t need your money, or, I don’t need any of this. And you know, off to the next person that doesn’t ask as many questions. So that’s another important thing. I wanna see that at least one operating partner is unrelated. And if there’s an issue, especially a family issue, you wanna know that there’s someone else there who can take over the operations. And this is also means that I like to see at least two operating partners.

Charles:
They don’t have to be managing partners. You know, you have partners in there that some will manage, some have different roles, but at least two partners at that firm that are gonna be calling shots at some point. I like operators primarily focused on one, maybe two markets if they’re investing with a general partner or a capital raiser. I wanna see that that capital raiser works mainly with two to three deal operators. You really just wanna see either way is that these people are focused, whether they’re the operator themself or whether they’re a capital raiser. I don’t wanna see capital raiser that’s doing here’s a deal for this syndicator. Here’s one, here’s there, you know, and they’re, they’re working with 10 of ’em. That doesn’t show a very strong relationship. It just shows that they’re putting out a lot of deals.

Charles:
Generating acquisition fees, honestly, seeing that they’re doing their fifth or more deal with an operator shows their relationship and trust with that operator. And also for operators that are in one or two markets, you really know that they have it honed, okay? They have all their people on the ground. You want to be one of those fifth properties, right? In the market for them where they have the management all set, they have their contractors all set everything is ready. You’re just getting plugged into their next deal into a system, into a process that already works. That’s the best way. Now I want to confirm that the deal operators are full-time investors. I do not wanna see a team of deal operators who are part-time syndicators. It just doesn’t work. Family offices will never invest with any part-time syndicators, and you shouldn’t either.

Charles:
Now, why also do not emphasize sponsors with higher education qualifications. Going to school and obtaining an MBA versus starting a successful business and continually making payroll through the ups and downs are two very different things. Going further, what are some deals specific red flags first deals with no preferred returns. I want to ensure that I receive a reasonable return before sharing the returns with the operators. Typically, preferred returns are usually 6% to 8%. So this means that a preferred return is returned to the limited partners, the passive investors first, and then there is a split above and beyond those returns. You wanna make sure that there is a preferred return so that you’re getting some sort of reasonable return and then you’re splitting it with the operators. The second red flag would be an operator’s first deal with a property management company. I do not wanna see the property manager change during my investment whole time.

Charles:
They should already have a current business relationship with the property management company, okay? And I don’t wanna be the operator’s first deal in a new market. I really wanna be, as I said before, their fifth deal in their current market with their current property management company. You know, how close are their deals to the subject property? The closer, the better for a couple of reasons. First, the property will not be overlooked during the property management and asset management visits. Okay? If you have all their properties are 15 minutes from each other, and then you’re investing in one that’s an hour and a half out, which one do you think is not gonna get as much attention? They most likely will be able to utilize the same general contractors on the new property as they will with their current properties, which is a huge plus I spoke about before.

Charles:
And if there are other properties are nearby, they will know the market better than most, usually giving them an advantage over other operators, well, hopefully making their underwriting more accurate. This is really important because they’re gonna know, know where those lines are. Every neighborhood has a line, whether it’s one street. I know exactly from my first real estate investments where the streets were, right? If you’re within, if you’re on this side of the street, if you’re on that side of the street, and they could, it’s, it could be something that you don’t even pick up on Google Maps. It’s something that you have to drive and you go, wow, that change really fast, right? When you’re driving through the neighborhood, trust me, when you have tenants that are driving to your look at your properties, they’re gonna see that too, okay? And they’re gonna see it every day on their way home from work.

Charles:
And that’s not gonna make them want to resign a lease with them. That’s the kind of tenants that you get for one year and they don’t renew. You don’t want that. You want to find the places where people will renew for many years to come. Another potential red flag is operators that model a refinance in the return projections. Now, the further down the road, the less accurate the underwriting model. So I always like to remove the refinancing event and see how the returns will differ and they’ll drop. I mean, they will, but the thing though was that if the whole deal rides on the fact of this refinance, that’s very risky, okay? I want them really focusing on telling me how the rents are gonna increase, how expenses are gonna be in control what they’re gonna do to save some money at the property.

Charles:
Like I want, I want, that’s what I wanna say. I don’t wanna see something. Oh, ho you know, and then down the road we’re gonna be able to refinance because if interest rates go up, you’re not refinancing probably or you’re not gonna be able to get this type of return in the refinancing and maybe refinancing doesn’t make sense anymore. Verify distributions are return on capital instead of return of capital. And how much are the sponsors contributing to the deal? I would like to see deal operators provide about 20% of the capital raised. Also, ensuring that the operators are financially sound is very important. If the deal requires more capital during that whole time, most general partners will provide a 0% loan to bridge any temporary cash flow constraints on our first syndication deal. As a gp, our lender was dragging their feet on the construction draws, right?

Charles:
So after we do work and, you know, do the renovation they would take it’s usually you know, weeks, right? And this was taking months to get our draw. So what we did is general partners put in an additional a hundred thousand dollars at a 0% loan to ensure we could continue renovating units at the pace we were going and we were able to complete the project and provide higher than expected returns to our investors. What is the business plan? Some operators like to promote a deal by saying that is been recently renovated and that is great for some investors, but that is not really a value add deal. That is more of a yield play deal. Yield play deal is a deal that’s already been renovated and you’re just kind of putting in long-term debt on it and it’s really just kinda like a cash register for you.

Charles:
Those are great, but you’re not gonna have the returns you will on a value add deal, okay? So for value add deals, I really wanna see a pathway for rents to be increased at least 20 to 25% after renovation. Now, if rents are currently at 1500, I wanna see comparable rent renovating units renting for at least 1850, $1,900 or more. That way I can put our units right there at 17 50, 1800 easily. You know, having a little bit of room between where there other people are renting at and that’s gonna make sure that these renovated units that you’ve just spent thousands of dollars on actually get rented right away. And the other thing too is that that’s gonna propel the property to really achieve that business plan. And those higher rents now income be es you know, income can be estimated pretty easily and you can look at the trailing 12 months and see what has been collected.

Charles:
But what about expenses? Expenses can be a little murky because most notably property taxes and insurance and how they’re coming up with these numbers and what are they estimating for annual increases for these two line items. Okay? So that’s a big thing because property taxes usually will jump, jump pretty high and they have to know, you have to know exactly how they’re coming up with these numbers and insurance, insurance has been going up a lot higher than it used to years back. So what are those increases? If you start seeing 3% increase on insurance you’ve gotta really change that. It’s probably gonna be two to three times what they were expecting for those increases. Now, what type of debt is being obtained? This is a very important one, especially in any type of higher interest rate environment or where an environment where interest rates have going up.

Charles:
Floating rate debt is not a wrong choice. If the deal is a heavy value add, deal with a lot of potential if the work is executed correctly. And this is an important factor because when interest rates go up, bridge debt and floating rate debt, they get a really bad name. However, people weren’t using them correctly, okay? The Kiyosaki saying, Robert Kiyosaki saying of like the debt it’s like a gun, it can be used against you and it can also shoot you in the foot. So the thing though is that you can use floating rate debt and bridge debt to do deals. The problem is that when people come in and they have yield play deals, so deals that are already renovated and there’s really not much to do and they’re putting on this aggressive debt on the property, you the, the value’s already been created, there’s not much you can do.

Charles:
It’s a difference. If you go into a place in the actual market rents are say $1,500 and you know actually like you’ve actually done comparables and they’re $1,500 if this was renovated and people are paying like nine, okay? $900. So that is a bridge debt type situation, okay? You’re literally gonna be raising rents by more than 50%, okay? Once they’re renovated that is where you’re making, that’s where you’re making returns and those are very difficult deals to come by. But that’s the type of deal where floating rate debt is not an issue because even if interest rates go up a little bit, you’re gonna have so much value increase, right? You can build so much product, create so much value during that time of doing those renovations that you’re still gonna come out ahead even if something happens and you have to refinance, you’re gonna have so much equity in the property that it won’t be that bad.

Charles:
And these are deals where you’re seeing current rents at the property. You know, like I said before, almost half what they are, right? Units haven’t been updated in decades and there’s deferred maintenance and this is where the massive value can be added in a rather short amount of time. And the issue with floating rate debt is that some sponsors use it for deals with minimal upside and deals with minimal upside are more yield plays and operators should use the long-term fixed rate debt. Now lastly, always confirm bank wire transfer details by calling the sponsor before wiring funds and having the sponsor read back their wire transfer details to you on the phone and then emailing them right after wire the wire after you’ve wired the funds to confirm they’ve received it. You know, us wires usually take about one business hour and they might have to reconcile ’em at the end of the day, so you might hear it back for the next day.

Charles:
But that’s one thing I do. I’ll call them, have them read it back to me, make sure the numbers are correct and then you can wire the money. And that’s just one thing. It’s another, another problem that investors have. With emails getting hacked, everything like this. Elaborate frauds with wire wire transfer. So just be very careful that, and by peaking a diligent pass investor, you can better protect your investment capital. And there is no right or wrong way of passively investing, but make sure that the deals you’re investing in have enough meat on the bone, which is a huge problem I see with deals that go south. So I hope you enjoyed, please remember to rate, review, subscribe, submit comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, please check out our courses and mentoring programs@syndicationsuperstars.com. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Charles:
Have you always wanted to invest in real estate, but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding and didn’t want tenants calling you. Since 2006, I’ve been buying income producing properties and great locations that provide us with consistent passive income. While we wait for appreciation in the future and take advantage of tax laws while we’re waiting and unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out to investwithharborside.com. If you like the idea of investing real estate, if you like the idea of passive income partner with us at investwithharborside.com, that’s investwithharborside.com.

Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.

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