We previously looked at whether investing in a real estate syndication is risky or not. Spoiler alert, yes investing in real estate syndications are risky, but investing in general is risky. The upside however is that real estate syndications of multifamily apartments provide one of the best risk-adjusted returns around when compared to other types of real estate investing and to investing in other asset classes like stocks. That means if you must take on risk then your best bet is to do so with real estate as you will be relatively well compensated for that risk.
Now that you know there are risks involved in investing in real estate syndication how do you find out about what the risks are in the specific deal you are investing in? In this article we will look at how you find out what the risks are and what are the 3 main factors that can increase risk in a deal.
What Are the Documents In A Real Estate Syndication That Tell You The Potential Risks?
Real estate syndications involve signing a lot more documents than buying a stock. The important documents in a real estate syndication serve a key purpose; they highlight the risks, potential rewards, rights and obligations you will have by making the investments. You will see the risks of the real estate syndication investment highlighted in the Offering Memorandum (also known as the Investment Summary) as well as the Private Placement Memorandum.
The Investment summary acts as the name states – it shows a summary of the overall deal highlights including the risks. Often syndication investments will be accompanied by an investor meeting (typically a webinar) where the lead syndicators will discuss the investment opportunity and related risks. Passive investors will have an opportunity to asks about risks and how they are addressed during this investor meeting.
The holy grail document of risks related to the investment is the Private Placement Memorandum. This lengthy document will include full length disclosures of all the risks that may come with the investment. There will be no sugar coating in the Private Placement Memorandum. As a passive investor it is important to review this section of the private placement memorandum in depth so there are no surprises once you have invested in the deal.
What Are The Factors That Make A Real Estate Syndication Investment Riskier?
The Private Placement Memorandum provides a laundry list of risks specific to a Real Estate Syndication Investment Opportunity. While this document provides a lengthy list there are 3 broad categories that sum up the general factors that increase risk in a Real Estate Syndication Investment. The factors that can increase the risk of a real estate syndication investment are:
· A market that is not ideal for investing
· A team without experience
· A deal with a poor business plan
A Market That Is Not Ideal For Investing
Location is king (or queen) in real estate. If you haven’t heard it before then this will not be the last time you hear that. When looking at a real estate syndication investment one of the first criteria you should review is the market. If you take all the necessary steps to evaluate a real estate market, then you will have more comfort that you are working with momentum in the case of a rising market. If, however your research shows that you are working against momentum and the market is declining this could spell trouble for your investment opportunity and make it harder for the investment to perform as expected.
A Team Without Sufficient Experience
Syndication is a team sport. An experienced sponsor team (the investors that lead the syndication) that is familiar with the market they are in and the business plan they will execute increase the odds of success greatly. This experienced team shows a track record of prior performance and being able to deliver on the promises that they make. A new and inexperienced team however may be liable to make mistakes due to lack of experience. It is possible for an inexperienced team to knock the deal out of the park, but this is an unknown as they have not had a long time to develop their resume. To help balance this out new syndicators may offer a greater portion of the returns to the passive investors. As there is greater risk there is greater opportunity for reward.
A Deal With A Poor Business Plan
The business plan for a syndication real estate investment tells you the story of how the sponsor team plans to manage the investment so that it can provide a reliable return to the investors. This may mean that they will operate the property business as usual to get a lower but stable return or they may do a value add plan to significantly upgrade the profitability of the property. Each business strategy carries its own level of risks. When the right strategy is paired with the right property then success is more likely.
If the sponsor team makes a poor decision in the business plan however it will most likely lead to over promising and underdelivering. For example, if the sponsor team is investing in a new construction apartment complex that was built last year and had a business plan to make significant renovations and upgrade the profit to get higher rents, this would not make sense. If the building is new construction, there would be little if any value gained from making renovations a year later. A more apt business plan would be to find operational efficiencies in the property and enjoy a lower but stable return over time.