If you are like me, you are getting offers in at least weekly for these *great* deals in Georgia or Alabama or wherever that make some amazing promises. Invest in this project and in the next three months you’ll start seeing returns and they predict doubling your money in a few short years when you are bought out and then have you’ll money to invest in their next deal!
These deals are called syndications. They have a key principal operator who runs the show. That person finds or employs people to find deals and negotiate with sellers. Once under contract, they draw up a pretty document that shows the potential returns. They talk to attorneys, line up insurance, property management, and many other things to make the deal work.
There are a lot of operators out there now who have started up after seeing the successes of others. There are operators out there who do produce great returns. The trick is to separate them and find the right one. Let’s face it – it’s been pretty easy to make money in real estate in the past few years. It’s a lot more difficult now. Inexperienced operators can show good previous returns. This is important, but not enough right now.
Really, the reason for investing in someone else’s deal is to gain the benefits of real estate investing, but not have to run the deal yourself. Everything is done for you. For this benefit, the operator gets a percentage of the returns. If done right, you become the proud new owner of an apartment building and everybody makes money. Done wrong, you get a capital call – where the operator asks you to put in more money. If that doesn’t come in, then the deal might go bankrupt and you lose your investment.
Risk vs. Return
There’s risk with these investments, like all investments. But, syndications will carry more risk in general, than a stock market investment. So, if you can reliably make a better return in the stock market than in a real estate deal, you should probably do that. Investors Business Daily predicts the S&P 500 to rise 5% over the next 6 months with nearly risk-free bonds at 3.76%. Your syndication deal better beat those to even have a seat at the table.
Look at Their Returns
Let’s say the operator is promising a 9% preferred return. You will be expecting a 9% return on your investment every year of ownership. If they are reporting a cash on cash return of 6%, you already know they won’t be able to pay you much in dividends because they are only bringing in 6% of the investment money, but promising you 9%! This isn’t necessarily bad, if the final sale of the property makes a lot of money. That’s the point of the preferred return – it gets paid back before the operator does. If there is a lot of upside later, like a heavy value-add deal, then this can work. Be wary of those who have this high return along with promises of monthly or quarterly distributions – they probably won’t be able to pay.
How Much are They Getting?
I like to use a 60/40 split (60% to investors and 40% to the operator). This is after all the initial investments are paid back along with the preferred return over the life of the project. When sold or refinanced, what is left over is subject to this split. In this difficult market, I’ve seen 70/30 splits or 80/20 splits. That might seem nice to the potential investor, but that leaves little incentive for the operator to do well. Also what if the deal doesn’t make as much as predicted? The operator could give some of their own split to make the investors whole. But if that split is not much, then there is no money to do so. These big splits are meant to entice investors, but might cause paradoxically lower returns in the end as they are a possible indicator of a weak deal.
Beware of excessive complexity in the syndication. There can be multiple classes of investors based on the earliness of investment, amounts, or other factors. They can have waterfall payments, ranges of returns, and triggers. Complexity is not necessarily bad, but makes it more difficult for you to determine what you are getting. The worst case would be if complexity is introduced to obscure what the investor is really getting. The documentation you get will be 100 pages of legal speak. That’s normal. Keep the terms simple, though.
Look at How the Syndication Closes
The end of the syndication is usually where the real money is made. The property should have increased in value. It is then sold to a third party (which is cleanest, but investors then don’t continue ownership), or it is refinanced. With a refinance, be careful to determine who will go on as the owner. Sometimes the operator will become the sole owner. Or the operator will be the buyer. Then, their interest is to refinance or purchase for the lowest possible price. This puts the operator in conflict with the investors and is a huge red flag. Refinancing is fine, as long as additional money is brought in by the new owner(s) and there is a plan required in the agreement for obtaining a true market value at the sale date. Without these, you need to look elsewhere.
Talk to the Operator
Lastly, have a real conversation with the operator. Make sure you have a good gut feeling about them. Don’t let this be your only criterion, but without it, you should run away. If they come off as a slimy salesperson, they probably are. Also, if they make you speak to an employee and not the key principal person, then avoid it.
All of these are here as basic things to look for in a syndication deal. The documentation is heavy and you really should read it all and have your own attorney review. It’s a small price to pay for your multi-thousand dollar investment. Make the right one and you’ll far outpace your stock investments. Feel free to send me an email if you have specific questions. I’m happy to help.