Real Estate Risks: What To Know Before Investing In Syndications
Real Estate Risks: What To Know Before Investing In Syndications
Recently, one of our Passive Investors Circle members (a 45-year-old anesthesiologist) reached out wanting to know more about real estate investing in syndications. Currently, he’s heavily invested with his financial advisor in the stock market and wants to start building additional sources of income to retire in eight years.
He was interested in general information regarding the risks of real estate syndications because he had two kids and capital preservation was important.
As a father of two boys myself, our investment goals are to buy assets that provide:
- capital preservation (moderate to low risk)
- tax advantages
Risk analysis is important because every investment, including real estate, comes with some level of risk. But there are some real estate risks that are higher than others.
It helps when the general partners of real estate syndications provide investors with ways to measure risk. By doing this, it gives the limited partners (passive investors) information to make sure that it fits their needs, goals, and risk tolerance.
As a passive investor, it’s important to know what these risks are so you can make sure they’ve been addressed.
In this article, we’ll discuss 9 of the most common risks in real estate syndication investments and how sponsors try to deal with them.
*Disclaimer: I’m a periodontist. Don’t take this information as legal advice, but for educational purposes only.
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9 Real Estate Risks In Syndications
When you invest in a real estate syndication, you’re putting money into a project that’s being run by real estate professionals (general partner). Usually, it’s up to this group to do all of the heavy lifting, such as:
- finding the right property
- property management
- acquiring debt
- raising funds from investors
Even though they take on the majority of the risk, it’s important to understand the information they present about their deal so you can make the best investment decision possible.
Some of the things they provide are:
- Operating Agreements
- other legal documents
Here are 9 real estate investment risks to consider:
#1. Liquidity risk
A common question I get asked is, “Hey Jeff, when can I get my money out if I invest in a syndication?”
The project’s hold time makes passive real estate syndication investments illiquid. If the asset is expected to be held for five years, you should expect to keep your money in the investment for five years.
Unlike stocks, mutual funds, or even real estate investment trusts, you can sell via a phone app at anytime, but that’s not the case with real estate.
In fact, before you invest, you have to sign a long legal document called a “private placement memorandum” (PPM) that explains the estimated hold time and the fact that the investment is not easily sold.
The bottom line is this: If you’re investing $100k in something with a five-year hold, then make sure you won’t need that money anytime soon.
#2. Market conditions can be unpredictable
In the run-up to the 2008 Great Recession, many investors (mistakenly) felt that the real estate market could only go up. The underlying notion was that if you bought property today, you could sell it for a higher price in the future.
Market risk is linked to changes in both the national and local real estate markets. If the economy enters a decline, all asset classes may suffer. On the other hand, even if the economy is doing well, there may be downturns in the local market.
While real estate values tend to improve over time, the real estate market is volatile, and your investment may lose value.
Real estate trends, including prices and rental rates, are influenced by:
- supply and demand
- economic conditions
- interest rates
- housing market
- government agencies and regulation
- unforeseen events
You may reduce your chances of being caught on the wrong side of a trend by conducting thorough research, exercising due diligence, and monitoring your real estate holdings.
#3. Structural risk
Not every real estate investment is perfect. The chance that property could incur unanticipated charges or capital expenditures due to its physical condition is referred to as “physical asset risk.” This is especially true for neglected and/or older buildings.
These properties may need costly repairs or modifications due to structural problems, reducing the investment’s profitability.
Typically, the group buying the property can limit physical asset risk by doing technical due diligence. And once the condition is known, there may be ways to talk about lowering the price.
When it comes to real estate investing, more than likely you’ve heard the phrase “it’s all about location, location, location.”
Location should always be your first consideration when buying an investment property, but it can also be a risk.
I learned this firsthand when I invested $50k in my first crowdfunding deal in Oklahoma with Realty Shares. The sponsor felt that dumping money into rehabbing an apartment complex would get tenants to move back in. Had I known that the area was high in crime, I would have NEVER invested in the first place.
The more you know about an area BEFORE investing, the better.
#5. Negative cash flow
To calculate the cash flow generated by a property, simply take how much income remains after all bills (expenses, mortgage, taxes, etc.) have been paid. This money is what you’ll be able to keep at the end of the day.
When the money coming in is less than the money going out, this is known as negative cash flow.
Some of the things that can contribute are:
- vacancy rates are extremely high
- not charging sufficient rent
- loans with high financing costs
- maintenance is too expensive
Preparation is key when looking to mitigate the risk of negative cash flow. Make sure you spend time estimating the expected income and expenses as accurately as possible for positive cash flow.
The number one reason I chose passive vs active real estate investing had to do with tenants. It’s too difficult to work in my dental practice and be a full-time dad while being a landlord. Who wants to deal with bad tenants, right?
The risk tenants impose is their ability to pay the rent. Something else to factor in is investing in property with only a single tenant (i.e. single-family home). These are generally riskier (in terms of vacancy risk) compared to properties that can house multiple tenants.
The reason for this is that when there is only one tenant, the occupancy rate is usually 100% or 0%. The longer it takes to get the property rented again, the more money that’s lost.
Another type of tenant risk is rollover risk. This refers to the danger that tenants leave at the end of their lease without renewing or ‘rolling over’ the lease, or that no replacement tenants are found.
#7. Debt risks
Most real estate investors (including syndicators) use leverage (debt) in order to buy rental property. Before signing on the dotted line, it is critical that you understand the risks involved.
For instance, if the loan is non-recourse, collateral is required by the lender which can be seized in the event of default.
Other issues may arise due to debt maturity risk or overleveraging.
It’s also important to understand what the debt service coverage ratio (DSCR) will be.
This metric indicates how much debt is covered by rental income. For example, a $900/month mortgage yielding $1,800/month in rent has a debt coverage ratio of 2.00.
Lenders may include a minimum debt coverage ratio in a loan covenant that the investor is obligated to meet. Most banks don’t lend below a DSCR of 1.0 to help prevent overleveraging.
#8. Cap rate risk
A cap rate is used to indicate the rate of return expected for a property based on a ratio of the current income to the market value of the property.
Investors use this metric to compare properties and estimate their potential ROI (return on investment) for a particular asset.
This metric is expressed as a percentage, and typically, the higher the cap rate, the higher the projected profitability.
Cap rates are calculated by taking the net operating income and dividing it by the market value.
Cap rate formula:
Cap rate = Net Operating Income (NOI) / Value
Typically, a real estate syndication sponsor will give the projected entry cap rate (when entering into the investment) along with the projected exit cap rate. Even a small cap rate change can have a big effect on the property’s value.
To reduce risk, it’s a good idea to research the current market of a property to ensure that projections don’t show too much of a decline in the cap rate from entry to exit without a good reason, which may be too aggressive in order to project higher returns.
#9. Sponsor risk
There are two main groups involved in a real estate syndication:
- Limited partners
The sponsor is also known as the operator, syndicator, or general partner (GP).
They perform all of the active duties due to their history of real estate experience. For example, they have the ability to underwrite and perform due diligence on each property.
Not only does the sponsor invest their time, they also invest their money. Typically, this amount can range from 5-20% of the total equity capital for the real estate investment.
In a nutshell, this group is “hands-on.“
Limited partners (LPs) are passive investors who are “hands-off.” This group invests passively and owns a percentage of the real estate.
They don’t have to do anything regarding taking care of the asset, but they still get all the benefits of owning property.
Their only job is to make sure the distributions hit their bank account :).
2 types of sponsor risk
Two types of sponsor risk are asset management risk and property management risk.
The asset manager is in charge of carrying out the business plan, and risk increases when he’s not able to make the project happen the way the business plan says it should.
Property management is also important to the success of each real estate asset, especially those where daily customer service is a must.
For instance, one of the reasons people choose a short-term rental to stay in has to do with reviews centered around property management.
If the customer service is subpar, then this can have a negative effect on its success.
Before you invest in a real estate syndication, make sure you ask about these risks to ensure you make the best financial decision possible.
Be wary of investment opportunities that don’t spell out all of the risks clearly.Join the Passive Investors Circle