How Do You Evaluate A Real Estate Syndication?

[Editor’s Note: The following guest post comes from a long time reader and paid advertiser on this site.  The author desires to remain anonymous.  It is written by a financial services professional and investor in syndicated real estate.]

Real estate syndications can be tempting, hands-off, lucrative, esoteric, and dangerous.  I have been a participant in many of them.  This post will be the first in a series on how to evaluate a syndication.  Hopefully, there will be additional posts on the specific results and details of syndications that I have participated in.  Briefly, a real estate syndication is where the accredited investor cuts a check to a real-estate operator that uses your money to purchase a multimillion dollar piece of real estate as an investment.

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Real Estate Syndications Are Not Exactly Passive

A syndication is passive, and it is not passive at the same time.  Let me explain.  There is a tremendous amount of due diligence required initially.  Before you cut that check, you had better be sure your due diligence has been completed.  After you cut that check, your work is essentially done, and you can sit back, relax, and enjoy the flight.

Due Diligence for Evaluating a Real Estate Syndication

Confidential Private Offering Memorandum

Most syndications come with a confidential private offering memorandum.  This is going to be your “go to” document for everything.  I have a feeling no one reads these.  It contains a treasure trove of information.  Typically, there is an introductory paragraph that provides a nice summary of the deal.  Next, there is a useful frequently asked questions section.  The down and dirty is the “risk factors” section.  Here is where you want to spend most of your time.  No one knows the risks like the promoter putting the deal together.  This is typically extremely well written by an experienced attorney.  Everything gets put in here because if there were ever a lawsuit, the promoter can reply “I told you that could happen.”  In fact, this is usually the part I read first after the introductory paragraph.

Scuttlebutt Method

In his famous book, “Common Stocks and Uncommon Profits,” Phil Fisher talks about how one of the most powerful investor evaluation tools is the scuttlebutt method.  I couldn’t agree more.  For example, during the construction phase of one project, I went by every couple of weeks and asked the workers hammering the nails how things were going?  Is there a cracked foundation when you poured it or was it done appropriately?  You would be surprised at what you might learn.  More importantly, track down the angriest investor from the syndicators previous deal.  Ask the syndicator to provide you with his most unsatisfied customer.  If the syndicator does not like your question or declines to answer it, move on to a different syndicator.  Your goal is to bring due diligence to a new level.  Talk to the secretary of the syndicator and ask what it is like working for him?  Speak to the accountant that handles the books of the syndicator.  Speak to the tenants.  Fly down and meet the team.

What are the loan terms?

This is key.  What kind of loan did the sponsor get?  What is the interest rate?  How long is it fixed for?  How much money was put down?  I have seen proformas that show an interest rate of 5 percent that changes after 5 years, yet the proforma assumes the rate will be fixed for 25 years.  Of course, that is revealed in the fine print.  Is the philosophy to pay down debt and then distribute money?  Or is there a teaser return that can change after 5 years?  Is there an interest only loan?

Other Items

Take the proforma with a grain of salt.  Even more importantly, jump down and look at the FINE PRINT in the proforma FIRST.  Literally, go to the bottom of the page and read the assumptions that they are trying to hide from you.  Make sure you know what the management fee is.  To paraphrase a risqué supreme court judge, I don’t know how to find an inappropriate management fee, but I know one when I see one.  5 percent is too high.  1-2 percent might be reasonable.  Most investors don’t pay attention to the disposition fee.  That is the fee the sponsor gets when the asset is sold.  Is it a reasonable 1.5 percent, or is it 5 percent?  Ask for any lease agreements between the tenant and landlord.  Have fun reading that, if you know what I mean.  The lease is about as entertaining as studying the proximal convoluted tubule and loop of henle.  Ideally, discuss the prospectus with a colleague who is also thinking of investing.  The creators of these deals are often talented salesman.  They will use every trick in the book (flattery, using your name, inflating your ego, scarcity principle, reciprocity etc…).  As a skillful salesman once said, “It’s not what you sell ’em, it’s what you tell em.” Another tip is to track down the competitor of the outfit that you are buying from.  That competitor is more likely to provide you with what you really need to know than the syndication outfit you are purchasing your shares from.

Diversification Equals Less Due Diligence

A recent prospectus that came across my desk asked for a minimum investment of $75,000.  If the astute investor wants to give syndications a try but does not want to do due diligence (pardon the pun and alliteration), a good trick would be to purchase smaller units in larger quantities.  Three different syndications at $5,000 each may be more palatable and more educational than one syndication for $15,000.  As the investor develops confidence in the provider, additional syndication projects could be purchased.

An Important Esoteric Pattern

Let’s face it.  Medicine is all about pattern recognition.  When 60-year-old hits the ED with a productive cough, elevated WBC, fever, and a RLL infiltrate on x-ray, bingo community-acquired pneumonia with standard antibiotics.  Investing is the same way.  I have noticed a pattern with my experience, and I wanted to share it with the WCI community.  An early operator just starting out, like Fundrise years ago, can be a slam dunk investment.  The just-formed operators are eager to make you happy, provide overly favorable terms, and in many cases, take a loss on you just to simply get your business and referrals again!  Searching out a new player with the above due diligence can be a superior combination.

real estate syndicationConclusions

Syndications are not for the faint of heart.  Although I am in them and have had favorable results with all of them, they require a lot of work before you cut that initial check.  These products are for the investor willing to put in the time and effort required to perform the due diligence.  They are completely optional in the sense that a busy physician can achieve her goals with 3 or 4 index funds without a fancy syndication.  For the casual business enthusiast that wants to get her feet wet, diversification over a few inexpensive syndications would be reasonable, educational, and most importantly fun!

What do you think?  Have you been involved in a syndication?  What were your results?  Comment below and join the conversation.