How To Mitigate Real Estate Syndication Investment Risk
Investing is risky.
There, I said it.
You could lose all your money.
There I go again.
Ok, this isn’t getting much rosier.
If anyone has told you different about investing, they were trying to protect you from a truth that you would eventually have to find out. Potentially you would find out the hard way. That shouldn’t paralyze you though. As an investor risk isn’t necessarily bad. What you should consider is how to handle those risks.
"How", you ask?
We will look at what is risk and how do we mitigate those risks in a multifamily real estate syndication.
What Is Risk Really?
The word risk implies the potential for loss. To have a potential for loss that means that you must put something at risk such as making an investment of money in a profit producing venture. Risk can range from no or low risk where you are protected from losing anything or high risk where you can lose your total investment or even more.
If you could make an investment that guarantees you will not lose any of your money, but rather that you would make a guaranteed return that would be your best option; it would be an ideal situation for the conservative investor. Would you expect to get a high return on this type of investment? Probably not. Anyone that is promising to guarantee you a high return and you have no risk of losing money – exit stage left, buyer beware. If some investment provider is saying they will provide you a return that is guaranteed then guess what, the risk didn’t really get eliminated; it just moved locations. The risk now lies with the investment provider. Given the investment provider is now taking on the risk of having to provide you that guaranteed return no matter what, they will probably only promise you a small return.
The small return increases the chance the investment provider will still be able to remain profitable but also make good on their promise of a guaranteed return. You can see examples of this low return trade off when you look at investments like US Treasury bills that return less than a percent. If there was some guaranteed high return investment with risk then everyone would be clamoring to invest in that asset, driving up the price and consequentially reducing the overall return. This would bring you back to square one of a low but guaranteed return.
Depending on where you are in your investing career and life, less than one percent may not get you too excited. There is a saying that fortune favors the bold (or something like that). As a savvy investor you will likely be more interested in opportunities that provide an outsized return in comparison to the risk of the investment. Enter Multifamily Real Estate Syndication.
What Is Multifamily Real Estate Syndication? – Risk Adjusted Returns
Multifamily Real Estate Syndication combines the benefits of multifamily investment with the safety of investing via a real estate syndication. Syndications combine groups of investors together to create the perfect team needed to complete investments that the individual investors would not be able to complete on their own.
Syndication itself is one of the best risks mitigating investment vehicles as it takes the risk off one person and spreads it across the partnership group involved in making the investment successful. This means your potential percentage of return remains the same but by investing via syndication you just reduced the risk.
To make this simple, imagine you have an investment that returns 15% and you have 100% of the risk. You can happily make your 15% and bear all the risk to potentially lose all your money. But what if you added 1 more partner? You still make 15% on your money invested but now your risk is 50%. If you want to do it yourself, you can but would that be the best way to manage your balance of risk and return?
What Are The Risks In A Multifamily Real Estate Syndication And How Do You Mitigate Them?
If you are wondering what the risks are in the syndication investment opportunity you are about to invest in, then you should be able to find a detailed list in the private placement memorandum. It’s even possible that maybe you are not ready to invest in this type of deal or have other reasons why you shouldn’t invest in a real estate syndication right now.
We’ve previously discussed some of the broad categories that risks fall into such as having a bad market, a bad team, or a bad business plan. Underlying all these risks is the ultimate risk of investing – that you will lose your money. One of the ways to mitigate this potential loss is looking for teams and deals that focus on capital preservation. As a passive investor, if you make capital preservation a key metric in your investment review process, you will mitigate many other risks upfront.
How To Mitigate The Risk Of Losing All Your Money
As mentioned previously, syndication provides you an opportunity to spread risk. When investing by yourself you may have to put all your money into one deal and would not have money left over to do more deals. When you invest in a syndication you may be able to put a fraction of that into a deal, still get the same amount of return you hope for and then invest in several other deals at the same time. Instead of having $100K in 1 deal you could make 5 investments of $20K that will each earn you the same return. If one investment does poorly it would be offset by other investments. Further if you invest via syndication and in a deal where capital preservation is a priority the chances of losing your money are lower. You may not get as good a return as you expected but a low return is a lot better than losing your money.
How To Mitigate The Risk Of a Bad Market
Why would anyone intentionally invest in a bad market? Maybe the market wasn’t bad when you started investing in the market. Perhaps there is data that shows the market will develop into a good market in the future. What ever the reason may be, people invest in bad markets both accidentally and intentionally. If someone is investing intentionally then there may be some insights that this person has which already will mitigate risks (such as insider knowledge of significant job announcements, coming attractions etc.); there is not much need to focus on this scenario.
In the case of the accidental investment in a bad market you will be on an uphill battle. Although a difficult situation, a bad market is not the end of the world. If the market is bad, then there may still be potential for investment success if there is an experienced team that has had success in the market. There may also be great submarkets that at the local level perform much better than the broader market. A team that has critical mass in these areas may be able to take advantage of their size to be more successful than stand-alone investors in the same market.
How To Mitigate The Risk Of An Inexperienced Team
The sponsor team drives a real estate syndication deal to success. They are like the pilots on the plane that is real estate syndication. An inexperienced team is more likely to make mistakes than an experienced team.
How does this get fixed? You can’t gain experience overnight right?
An inexperienced sponsor team can’t gain experience over night but if they are surrounded by experienced and wise counsel their odds of success are higher. Does the team have some members that are highly experienced to balance out the group? Do they have auxiliary members such as a construction manager and property manager that have significant experience? An inexperienced team that has a board of experienced advisors, talented auxiliary team members or a balance of experienced core team members is more likely to succeed. Further if you are investing in a extremely good deal or rising market this could compensate for mistakes made by an inexperienced team. As a passive investor make sure to vet the sponsor team prior to investing.
How To Mitigate The Risks Of a Bad Business Plan
Real estate syndications are like turning a ship around. Changes in direction are not instant but are seen over time. If a business plan is bad this could be a killer to having a profitable investment. By having a bad business plan, I do not mean that the investment falls short of expectations but rather that the business plan does not fit the market, deal, team experience etc. If a deal just falls short of expectations, then the impact would be mitigated somewhat by the emphasis on capital preservation upfront. If the business plan just doesn’t make sense all together this should be vetted out during your initial deal review. Once again capital preservation would help mitigate this risk as the deal would have multiple exit strategies in case the business plan fails.
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