How to Evaluate Real Estate Syndications, Part 3: The Deal
This is the third and final installment of a special 3-part series on How to Evaluate Real Estate Syndications. The first article shared how to vet a sponsor. The second piece focused on evaluating the market. This final piece addresses how to review the actual deal and investment opportunity.
Before we jump into the actual deal, it’s important to reference the key takeaways from the first two pieces. The operator is going to be the most important aspect of the deal. They should have the ability to pull together an all-star team and demonstrate an ability to develop and execute a solid business plan. The operator should also be resourceful enough to navigate challenges that may arise.
The market should have strong fundamentals which include a growing population, diverse economy, growing demand for multifamily, and affordability. With that noted, the sub-market dynamics are going to be more critical when reviewing the deal. In particular, you’ll want to understand what the drivers are in a given submarket and explore the trajectory for future demand.
When it comes to reviewing the actual deal, you are looking to understand the logic behind the projections to determine your comfort level with the deal and projected returns. The key areas for you to evaluate and understand are the equity structure, business plan, financial projections and potential risks.
One of the first things you’ll want to understand is the deal structure. In a debt structure, your investment is treated like a loan with a set rate of return. In an equity deal, your returns will align with the performance of the asset. Most of the syndications we see are equity deals.
In these equity deals, you want to understand the splits and any performance hurdles. Generally, the equity split is in the 60%-85% range for limited partners, with 15%-40% for general partners. While it may be intuitive to prefer a deal where the investors have more equity, it’s important to ensure the sponsor has enough equity to be incentivized to prioritize the project and do whatever it takes to see it succeed.
The deal may include a designated preferred return, which states that profits of a certain amount are paid to the investors before the general partners collect profits. This prioritizes payment to investors and provides a sense of assurance that the sponsor will have incentive to execute and drive performance since they won’t get paid until they exceed the preferred return.
There may be other performance hurdles that reward the general partners for exceeding expectations, which is referred to as a waterfall structure. In this scenario, the equity split may change from 70/30 to 50/50 on all profits that exceed a specific return. Let’s say the sponsor projects to deliver a 2.0x multiple on the investment, doubling the investment. They may add a hurdle that states once this is achieved, all profits above and beyond the corresponding amount would be split 50/50.
Next, you’ll want to understand what fees are involved with the transaction. It is common for operators to add an acquisition fee, as well as an asset management fee. Both range from 1-5% typically. You may also see construction fees, disposition fees, and others, but these are the most common. You should be concerned if you see an abundance of high fees, but understand many sponsors are not getting properly compensated for all the time they commit to organize and manage the project. These fees actually help to cover some of the time and out-of-pocket costs associated with managing the asset, unlike a stock broker who charges a fee simply for processing an order. Expect to pay higher fees for more established sponsors.
The business plan lays the foundation for the underwriting and return projections. Not to be overly simplistic, but the plan should be logical based on the target market dynamics with a clear objective, strategy and tactics. If it’s a value-add strategy to improve rents by attracting a higher quality tenant, you should be able to find other apartments in the area that are achieving the rent premiums and attracting the desired tenant base. The operator should be able to identify which amenities and improvements are needed to compete with those properties and potentially exceed them.
If the plan is to reposition a Class B apartment community as an alternative to Class A apartments, you would expect a hefty renovation budget with higher end finishes. However, if the plan is to reduce the economic vacancy - physical vacancy plus all income lost due to bad debt, concessions and below market existing leases - the solution from an underwriting or budgeting perspective is not as clear. Nonetheless, the operator should be able to demonstrate why the plan makes sense for the market and how they plan to achieve it.
Forecasting income and expense projections can be complex, especially because each deal will have different assumptions based on the market dynamics, multifamily demand, capital improvements, and debt terms. Two people can underwrite the same deal and get vastly different results based on their vision. As a passive investor, your job is not to underwrite the deal yourself, but to ensure you feel confident in the operator’s assumptions based on the business plan and market dynamics.
When reviewing the figures in the underwriting, you want to compare current operations to the Year 1 and future projections. Which numbers jump out as a big increase or large decrease? Is this in line with what you would expect from reviewing the business plan? If something stands out, make a note and ask the operator to share their assumptions on the item. This should not be an accusatory question, simply seek understanding of their rationale. Note that the first year of operations for a value-add deal will see fluctuations in physical vacancy, economic vacancy and overall cashflow projections. The operator should be anticipating this in the projections if the plan includes improving interior units.
Ideally, the deal will have conservative projections for renovated rents based on market comps, a higher exit cap rate and sufficient reserves to cover operational expenses. A sensitivity analysis is a great way to understand how conservative the underwriting is in a deal. This will lay out how returns are impacted by different scenarios including a decrease in vacancy, expansion of cap rates and longer hold periods. The deal should have elasticity to still be profitable even if there is a swing in operations. You’ll want to avoid any deal that requires everything to go right for it to be successful.
As a passive investor, you probably just want to understand the answer to one question: “how can I lose my money on this deal?” The specific answer will vary based on the type of real estate deal as some strategies have more risk than others. However, the factors that would cause an investor to lose money come down to the following:
If the cashflow does not cover all expenses and the debt service, investors could be at risk of losing their investment. This is especially true for development deals or distressed assets that will not have enough cashflow to cover these expenses in the early stages.
Precautionary Steps: You’ll want to see reserves and operational capital to cover any shortcomings through and beyond the timeframe when the operator believes the property will be cashflow positive. Even if it’s a cashflow positive deal out of the gate, it’s great to have an operational budget for added precaution.
Lower than Expected Exit Value
When it’s time to sell, if the net operating income is lower than projected or the cap rate has expanded, you could have a lower value than anticipated.
Precautionary Steps: You want to see conservative estimates for renovated rents, rent growth and/or expenses. In addition, projected exit cap rates should be higher than the entry cap. Look into value-add investments that focus on cash-flow and forced appreciation.
Loan Maturity during Market Turn
Many of the people who lost money during the last recession did so because they had a loan that matured and could not secure a new loan either due to a lower valuation or tighter lending requirements. In this case, an operator has three options: pay off the loan balance, refinance with less than ideal terms or sell for whatever they can get.
Precautionary Steps: Long-term fixed debt has less risk than an adjustable, short term loan. However, short term loans have a purpose. Look for added protection through loan extensions and caps placed on variable interest rates. Also, ensure that the sensitivity analysis shows how much equity needs to be created to refinance into a longer-term loan. If you have an initial loan at 80% LTV and need 65% LTV for a refinance you may need to come up with more money out of pocket just to refinance.
Limited Insurance or Zoning Change
Lastly, there are factors an operator can’t control once the purchase is made such as natural disasters or zoning changes. Insurance should cover natural disasters and lawsuits, but it doesn't hurt to understand the coverage in these policies. Zoning changes impact new developments more than existing properties, but you’ll certainly want to make sure the local government supports the construction plans.
Like all real estate deals, there are risks with passive investments, but the scale and professionalism of all the parties involved from contractors, property managers, lenders and others tend to reduce this risk.
Hopefully, you found great value in this series to help you vet sponsors, markets and deals. As a passive investor, the most important part is vetting sponsors until you find a team you know, like and trust. Whether you are looking to grow or simply protect your wealth, real estate syndications are a phenomenal tool to help you achieve your financial goals.
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