7 Things to Look for When Evaluating Real Estate Syndications
Want to invest in a real estate syndication passively but not sure where to start? Don’t worry, it’s actually not as intimidating as you think!
A syndication typically requires $35,000 to $100,000 minimum investments, which can be daunting. But if done right, it is one of the greatest investment strategies and provides you great passive income.
Here are some tips to help you! Although these tips are mostly for apartment syndication, the same concept can also be applied to syndication for other property types.
Before you start looking for deals, you want to know your own investment goals, such as the desired annual return, the investment period, and the risk tolerance.
Are you looking for investments with higher returns and risks, such as ground-up developments or an extensive value-add? Or do you prefer less risky investments that provide lower but stable returns for many years? Although higher return is obviously better, those types of real estate investments are generally more risky.
For more information on the different investment types, time length, and returns, read this: “Multifamily Real Estate for Beginners (& Why It’s SUCH a Wise Investment!).”
Finding the Right Syndicator
A syndicator with a track record is preferable, but don’t let it be your only criteria! Many syndicators started after the last recession, which means they probably haven’t experienced a market downturn yet. Therefore, you should always trust but verify the syndicators that you invest with.
I’ll show you in the next section how to verify their underwriting.
On the contrary, a syndicator without a track record isn’t necessarily a deal breaker. Even the greatest real estate investor must start somewhere, right? Instead of walking away from a potential great deal, ask if there are experienced partners in this deal. If the answer is yes, then it’s a good sign.
So, how do you know if the syndicator is right for you?
Different syndicators have different investment strategies, so make sure that the person’s strategy aligns with your investment goals and criteria.
You also want to work with someone that you find pleasant to work with. Your gut feeling is also very important!
If you like the syndicator’s strategy and personality, then ask the person to put you on the distribution list. You’ll start getting emails when there’s a potential deal, and this is when the fun begins!
How Do You Know If a Deal Is Good?
You don’t need to fully underwrite the deal, but here are some numbers or metrics that you absolutely should pay attention to!
1. Returns and Investment Period
The first thing you should look at are the returns and the investment period, which we discussed earlier under the “Investment Criteria” section. If you like what you see, then follow the steps below to double-check the syndicator’s work!
Even though you trust the syndicator, it’s good practice to verify the underwriting. Since you’re putting $35,000 or more into a single deal, you should do your own due diligence.
2. Exit Cap Rate
This is arguably the most important variable in an analysis, and also one of the hardest to pinpoint, especially if you’re operating in a market with small sample size. This variable is so important, because a small difference in the cap rate can change your sale price and returns dramatically!
The rule of thumb is that the selling cap rate absolutely needs to be greater than your market cap rate. For example, if you’re buying the property at 5 percent cap, don’t assume that you’ll sell at the same cap rate in the future. You want to assume that the economy will be doing worse in five years. A good estimate is five basis points a year, which is 5.25 percent in five years.
Note that if you’re buying a distressed property, then the going-in cap rate is probably even lower than the market cap rate. That means your cap rate at disposition could be higher than your going-in cap rate by as much as 1 percent!
You can find the market cap rates through LoopNet, CBRE, local brokers, or local property managers.
3. Rent Per Square Foot
Rentometer is a great reference for rent per square foot, but it’s not the most accurate. Try using Apartments.com to find comparable properties and see if the rents per square foot are similar.
You’re basically checking whether you think the units will be able to lease at the market rate that the syndicator is using for the underwriting.
4. Expense Ratio
It’s more time consuming to check the annual cost of each individual expense, and it’s not necessary for the purpose of this exercise. Instead, you want to do a quick check on the expenses by comparing it to the effective gross income (EGI). Note that the expense ratio does not include capital improvements/expenditures.
The expense ratio varies based on the city and the building type. A newer building is going to have lower expense ratio, because the equipment requires less maintenance. An expensive city will also have lower expense ratio, because the EGI is so much higher.
Generally, the expense ratio should be about 40 percent for newer buildings and 50 percent for older buildings. If you’re not sure, check with a local broker or property manager.
5. Rental and Expense Growth Rate
You can typically assume that the rental and expense growth rates increase at about 2 percent annually, which is similar to the inflation rate. If the projected rental growth rate for the deal is higher, then you should double-check by referencing the city’s historical data.
6. Stress Test
If you don’t see a stress test analysis in the syndicator’s investment summary package, then you should ask about it. The main thing to look for is cash flow. You want to know if the property will have enough cash flow to pay the expenses and debt service with decreasing rent, higher vacancy, etc.
7. Risk Partitioning
One way to analyze the risk of each deal is by partitioning the IRR.
To partition the IRR, you need to normalize the net operating cash flow and the net sale price by using the Present Value (PV) function in excel. Then you can partition the IRR by simply adding the cash flow for each year and dividing it by the total PV.
For example, 40 percent of the IRR for a buy and hold property might come from the net operating cash flow, whereas it may only be 10 percent for a ground-up development deal.
The lower the percentage, the higher the risk, because the gains are not realized until you sell the property.
Note that if 10 percent of the IRR partition is coming from the net operating cash flow, then 90 percent is coming from the sale. A very risky deal but potentially very high return!
If you made it this far through the article, then you’re already way ahead of other investors. This may seem like a lot of work at first, but you’ll be able to do it relatively quickly as you go through more and more deals. It shouldn’t take you longer than a couple of hours to verify these numbers, especially if you’re familiar with the market already.
A few hours to make sure that you don’t lose tens of thousands of dollars is time well spent. No investments are bulletproof to recessions, but by choosing your options wisely, you can minimize the risks significantly.
Do you look at deals differently? What are the main things that you evaluate when considering a syndicator’s deal?