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Real estate syndications have become a popular option for investors seeking to tap into the lucrative world of commercial real estate.

A syndication includes a sponsor and one or more investor partners. The sponsor (also referred to as the “syndicator, manager, or general partner”) is a firm that offers a passive investment in real estate projects. The sponsor is responsible for finding appropriate properties, performing due diligence, managing escrow, and raising the capital required to purchase and improve the properties. During ownership, they are responsible for the day-to-day management and maintenance, completing improvements, and the overall performance of the property. The investor’s role is simply the contribution of capital.

In a properly managed syndication, the investors receive tax benefits and cash flow during the period of ownership, and the return of their original contributed capital plus a lump sum of profit from appreciation when the property is sold.

The Driving Forces Behind The Success of a Real Estate Syndication: the Integrity and Experience of the Sponsor

While there are many good sponsors offering exposure to passive investment through syndications, there is a darker side to this industry that investors must be aware of. Much of the risk in a syndication correlates with a sponsor’s integrity and experience, or lack thereof.

The matrix below demonstrates the type of sponsors who are potential stewards of investor capital, based on the amount of integrity and experience present.

52ten integrity experience quadrant

INTEGRITY

The single most important thing for investors to get right is the people behind the investment. In a syndication, investors are trusting their capital to the sponsor, who will make all the decisions related to the acquisition, improvement, management, and sale of real estate without the investor’s input. It is paramount to select a sponsor who will be a good steward of the investment and the decisions made around it.

The ideal sponsor will have strong ethics and morals, interests aligned with all parties, and measures in place to ensure transparency and accuracy. In the best case, a neutral party referee in the middle reports the truth at regular intervals and ensures accurate distributions of cash flow, tax benefits, return of capital, and profits.

LACK OF INTEGRITY

When a sponsor has insufficient integrity, even if they are great at real estate, investment capital will be exposed to loss from common situations such as:

  • Hiding the truth, stretching the truth, or outright lying – one of the primary issues with sponsors is the propensity to exaggerate or manipulate information. This is done in an effort to entice investors, downplay or hide potential risk, and present a rosier picture than reality, both before and during ownership of the real estate.
  • Lack of reporting, false reporting, or going completely dark – even if the real estate is okay, lack of proper reporting causes investors to lose sleep and assume the worst when they lose communication.
  • Skimming – a lack of strong morals, poor reporting practices, and missing a neutral party in the middle can lead to greedy hands in the cookie jar.
  • Ponzi – we’ve all heard the story of Bernie Madoff.
  • Misalignment of interests – ethics may take a backseat for some sponsors as they prioritize their selfish interests over proper stewardship of investor capital.
  • Taking investor depreciation – depreciation is a key tax benefit for real estate investors and some sponsors will retain some or all the depreciation benefits for themselves, depriving investors of this valuable tax benefit.

EXPERIENCE

Coupled with getting the people right, it is important to ensure the sponsor has adequate experience. The ideal sponsor will have a track record of sourcing great deals as well as solid performance from both current and full-cycle projects. They will likely be vertically integrated, and will have an experienced team, proven processes for doing business, and strong accounting and bookkeeping practices. All of these will have an impact on accurate and timely reporting, distributions, taxes, overall yield, and the entire experience for investors.

Essentially, investors should make sure they are investing with someone who knows what they are doing, have done it long enough, can overcome challenges, and have demonstrated a clear history of success.

LACK OF EXPERIENCE

When a sponsor has insufficient experience, even if they have good morals and work ethic, the projects will be exposed to risk that comes from common mistakes such as:

  • Aggressive underwriting – we’ve all heard the common phrase “you make your money when you buy,” and that is more true today than ever. When a sponsor is motivated to place capital, they can become too aggressive with the inputs in their underwriting. Some common examples of assumptions that will cause projects to go poorly are unrealistic leasing and rent growth speed, future expense increases not accounted for, and timing of refinance or sale that doesn’t leave room for market and interest rate volatility.
  • Overpaying or acquiring in a poor location – even the best sponsors cannot overcome the purchase of a bad deal.
  • Taking unnecessary risk with debt – while short-term or floating-rate debt instruments can be useful tools in certain situations, some sponsors employ them recklessly. This leaves investors vulnerable to interest rate fluctuations and in a worst case scenario, loss of the property to the lender, resulting in total loss of invested capital.
  • Lack of operational experience – inexperienced sponsors tend to project unrealistic timing with respect to the strategy for the property, focus on the wrong strategy, or lack the skills and team to execute on the strategy.
  • Human error – this tends to occur when a sponsor has the wrong person in charge, is missing staff with the appropriate knowledge and skill set, or simply hasn’t been around long enough to learn the nuances of the business.

With an inexperienced sponsor, the best outcome will leave investors with a poor experience and lack of sleep, but the worst outcome is total loss of investment capital.

Summary

The purpose of investing passively is to leverage the sponsor’s time, expertise, and ability to source great deals, but if the experience is going to cause you to lose sleep at night, any return you might make simply may not be worth it.

Investing in a real estate syndication can be profitable when the sponsor managing the investment has sufficient integrity, experience, and genuine concern for investors’ best interests. However, as in any industry, there are sponsors that lack those intrinsic qualities, raising the potential for severe consequences for investors, including financial loss.

To avoid these risks, investors should thoroughly research and vet potential sponsors to understand their track record, expertise, financial practices, and commitment to transparency. With this approach, investors can enjoy a passive investment experience with all the benefits of owning real estate but without all the hassles or the potential costly mistakes.

This content is the perspective of the author and is not intended to be relied upon as a forecast, recommendation or investment advice, and is not an offer or solicitation to buy any securities or to adopt any investment strategy. The information and opinions contained in this content are derived from experience, historic data, and other sources deemed to be reliable, are as of the date of this content, and may change as subsequent conditions vary.

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