Real estate syndication allows both accredited and non-accredited investors to pool their money together and invest in larger commercial properties. While syndications can provide attractive returns, they do come with risks that need to be evaluated. In this article, let us explore the biggest risks when investing in a real estate syndication and proven tips for mitigating those risks.
Untrustworthy Or Inexperienced Sponsor
The sponsor leading the syndication plays a huge role in its success. Working with an untrustworthy or inexperienced sponsor represents a major risk for investors. Only invest with sponsors who have a long track record of successful projects under their belt. Vet their background, partnerships, and previous investor experiences. Ensure they have the expertise to identify sound deals and manage the assets to add value. Beware of new syndicators making unrealistic projections without evidence to back them up. Investing with an unproven sponsor puts your principal at risk. Lean on trusted relationships and proven operators.
Overvalued Acquisition
Another key risk is the sponsor overpaying for the property acquisition and overleveraging the asset. Make sure the sponsor sufficiently justifies their purchase price with comparable sales, income projections, and accurate valuation assumptions. Review the occupancy history, rent rolls, costs, rents, and operational efficiencies to assess income potential. Confirm the debt terms and structure allow for a reasonable debt service coverage ratio. If the sponsor overpays or takes on too much debt, the investment could fail even with competent management. Ensure the underwriting withstands conservative scrutiny.
Poor Business Plan
Syndications with poor business plans carry significant downside risks. Make sure the sponsor details a specific value-added thesis with realistic projected returns. Confirm they have justified improvement costs and timeframes with quotes from contractors. Review their comparable rent studies and demand analysis to support increased rental rates. Analyze their projected occupancy ramp-up schedule and expense reductions. A speculative or half-baked business plan puts your investment at risk. Demand detailed, realistic projections.
Lack Of Investment Diversification
While tempting to maximize returns, investing your entire real estate syndication allocation into one deal is quite risky. You expose yourself to the unique risks of that single market, property type, sponsor, and business plan. Diversifying across multiple syndicated deals increases the odds that some will outperform while others underperform. Working with multiple successful sponsors also reduces sponsor-specific risks. Diversification reduces the downside risk of any single deal wiping out your whole investment capital.
Inferior Corporate Governance
Syndications with poor corporate governance provisions leave investors vulnerable to harmful actions by sponsors. Ensure the operating agreement requires high sponsorship equity, priority distributions for investors, removal capabilities for bad actors, investor voting rights, pro-rata rights for follow-on deals, timely reporting, audited financial statements, and other investor protections. Selecting syndications with shareholder-friendly terms reduces the potential for sponsor misdeeds that harm investors. Corporate governance matters.
Excessive Fees
Another risk area is sponsors charging unjustified fees that siphon profits from investors. Examine the acquisition, asset management, disposition, promotion structure, and other fees charged by the sponsor. Make sure their projected returns properly reflect all fees and carried interest. If fees seem excessive for the services rendered, it is a big red flag. Reasonable fees ensure the sponsor’s interests align with investors to drive profitable growth. Watch for misaligned incentives from greedy sponsors seeking quick paydays through unjustified fees.
Inadequate Reporting Transparency
Lack of transparency around property operations and financials introduces risk. Sponsors should provide timely, audited updates on items like occupancy, revenues, expenses, capital projects, debt service, and valuation. Insist on transparent reporting standards in the offering memorandum. With quality reporting, investors can monitor the investment progress and spot any issues requiring intervention. Transparency ensures alignment between sponsors and investors.
Refinancing & Disposition Challenges
Syndications carry the risks of challenges when it comes time to refinance or sell the asset. Markets may stagnate or decline, preventing lucrative sales or making refinancing impossible. Insist sponsors get reasonable loan terms to mitigate refinancing difficulties. Select syndications with multiple exit strategies so you are not dependent on a single one. Avoid speculative deals relying solely on a forced appreciation sale. Refinancing and disposing of assets has risks requiring thoughtful mitigation.
